FOMC Preview Use the force Janet

I thought “Star Wars: The Force Awakens” was an incredible movie. That may seem like a weird way to start a report about the Federal Reserve’s January policy meeting, and it is, but bear with me.

Matt Weller
By :  ,  Head of Market Research

I thought "Star Wars: The Force Awakens" was an incredible movie. That may seem like a weird way to start a report about the Federal Reserve’s January policy meeting, and it is, but bear with me.

The movie had a massive scale, constant action, interesting characters, and most importantly for me, a plot that even an extremely casual Star Wars fan could follow (as in, I last watched Episode 4-6 a decade ago and have seen bits and pieces of Episodes 1-3). While I loved it, the much bigger Star Wars fans with whom I saw the movie (namely my wife and Father-in-Law), gave it mixed reviews, not because they thought it was a bad movie, but because it didn’t live up to their expectations from the first six movies, not to mention the countless trailers they had seen and spoiler articles they had read.

Tomorrow at 2:00pm ET (19:00 GMT), the Federal Reserve’s Open Market Committee will announce the results of its first monetary policy meeting of 2016. The central bank will almost certainly leave interest rates unchanged in the 0.25-0.50% range and there will be no press conference or updated economic forecasts, so traders will key in on the central bank’s monetary policy statement. In other words, get your reading-between-the-lines glasses ready, because there’s going to be a lot of speculation about what the central bank will be doing moving forward.

Since the Fed’s hiked interest rates at its last meeting in December, the US economy as evolved roughly as anticipated. On the positive side, the December Non-Farm Payroll report was solid at +257k jobs, consumer confidence has improved, and the trade deficit has narrowed. That said, we’ve also seen deterioration in price pressures, retail sales, and activity in both the Manufacturing and Services sectors. In isolation, US economic developments would argue for leaving the statement essentially unchanged and sticking to the plan for a likely rate hike (or at least a hotly-debated decision) in March.

The problem, of course, is everywhere beyond the United States. The start-of-the-year collapse in Chinese equities has spilled over into other markets, prominently including key commodities (including oil) and US stocks. The resulting financial turbulence will likely prompt the Fed to adopt a more cautious approach and give tomorrow’s statement more of a dovish bent. At this point, traders should expect a nod to the "increasing risks overseas," potentially along with comments about the negative impact of the renewed drop in oil on price pressures.

In other words, casual traders who look merely at the change from the previous statement will be like me with Star Wars: late to the party.

That said, with a full seven weeks, two non-farm payroll releases, and two monthly inflation reports scheduled for release before the Fed’s March monetary policy meeting, we doubt the central bank’s statement will imply that a March rate hike is off the table; it would be far more prudent to make some minor dovish tweaks to the statement and leave the door open for a March rate increase if conditions improve over the next two months.

While we remain highly doubtful that the central bank will be able to achieve its aggressive goal of four rate increases this year, Feds Funds futures traders are only pricing in single rate hike this year and about one in four odds of an increase in March. Given the market’s extremely low expectations for the March meeting and our view that the Fed won’t explicitly rule out a March rate hike, it’s unlikely we’ll see a dovish surprise that could drive the dollar meaningfully lower. That said, even if the statement comes out less dovish than expected, any dollar rally (and corresponding weakness in US equities) will likely be short-lived given the high degree of uncertainty.

Whether Janet Yellen and company will be able to "use the force" to control the market’s animal spirits or not, it’s clear that the market has Star-Wars-like expectations for a dovish shift tomorrow. The big question is whether the Fed can meet those expectations or whether traders, like my father-in-law, will walk away unimpressed.

* We have been nominated in the "Best Analysis" category in the FXStreet Forex Best Awards 2016. If you enjoy our daily reports, you can show your support by voting for us here (be sure to complete the whole survey!). Thank you for your continued support of the research team! *

For more intraday analysis and market updates, follow us on twitter (@MWellerFX and @FOREXcom)

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