The Fed made history in December by raising the rates for the first time in nearly a decade after an extremely long preparation. Despite putting an emphasis on inflation, Janet Yellen and her colleagues expressed confidence and according to their own dot-plot, they are theoretically on track to hike rates 4 times in 2016. An even spread of these hikes implies one coming up in March.
The world did not collapse on that historic move, but after the holidays came and went, stock markets suffered quite a bit. Worries about China, its stocks and currency, oil prices, global demand geopolitical issues joined not-so-convincing US data releases. Will the stock-sensitive Fed respond and hint of a hike-hiatus? Or will it stick to its guns? It can also be something in the middle. Here are 4 scenarios, with probabilities and impacts on currency markets:
Dovish because of markets: In this scenario, we have a repeat of the September rate decision, in which the Fed decided not to hike because of financial market turmoil. Also then, it was the Chinese stock market fall in August that made the Fed sit on its hands. A statement saying that the economy looks OK but for the next hike they would need to examine also financial stability conditions and go gradual would of course be positive for stocks. It would also be positive for other “risk” assets such as oil and commodity currencies. Less pressure on emerging markets is good for commodity exporters. CAD, AUD, NZD and also GBP could gain. Such a statement would also imply that the US economy is doing well and can lead the world economy forward. The good news comes from core inflation at 2.1% y/y, which removes worries expressed by the Fed. And the other Fed mandate, jobs, looks great according to the jobs report. Such an environment is not favorable for the doom and gloom safe haven euro and yen, which would slide despite a dovish Fed.
Dovish because of the US economy: A hint that there is no rush to hike in March could result in a very different reaction if the reason is the US economy. And while the recent NFP and inflation reports are good, retail sales, the manufacturing sector and GDP prospects in general are not looking good at all. Jobs could be lagging: they are still rising while the recent slowdown could be reflected in jobs only later on. The US releases the first estimate of GDP on Friday and the Fed may already have the data in front of their eyes. If they err on the side of caution because they worry about the economy and not markets, the outcome could be different: a risk off move favoring the safe haven euro and yen while further depressing all the rest. The reason for not hiking is critical for the reaction.
Hawkish all around: In the somewhat less likely scenario that the Fed hints that the next move is coming in March, barring any major disaster, we could see the US dollar storm across the board. Markets are expecting some kind of dovish move and if they don’t get that, it’s not only commodity currencies that suffer but everybody, especially after Draghi went dovish and the BOJ is also ready to act. It would also imply a super-strong GDP report on Friday, which also has low chances.
A finely balanced statement: This is probably what the Fed will do its best to achieve as it wants to leave all the doors open towards the next meeting and they certainly do not want to rock financial markets. Their well crafted December decision triggered a very calm reaction. However, this time, the Fed can try the best tricks in the circus, but it is hard to see markets remain calm. This scenario has the lowest probability not because the Fed does not want that, but because markets will look for the subtle hints and choose a direction. They could try and say that employment is good while inflation needs improvement, and that they are cautiously optimistic, or any other kind of attempt to say everything and not say anything. We could have choppiness in a limited range at first, until the verdict falls on one of the three scenarios, with a higher probability of scenario No. 2 – a sell-off and a resumption of the “risk off” mood.
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