Fed to press the rate cut button
The dollar rebounded against most of its major peers on Tuesday but resumed its slide early today as traders appear reluctant to assume a clear direction ahead of the very important Fed decision later today, when the Committee is expected to begin its rate-cut cycle.
Investors are not concerned about whether officials will hit the rate-cut button or not, but rather how hard they will hit it. In other words, a reduction is a done deal, but the uncertainty lies around the size of the reduction.
But will it be a 25 or 50bps reduction?
Following signs of softness in the labor market and reports that officials are actually thinking about beginning this easing cycle with a bold 50bps decrease, the probability for such a move lies at 60%, with the remaining 40% pointing to a smaller quarter-point cut. As for the whole year, traders are penciling in around 116bps worth of reductions by the end of the year.
That said, with the Atlanta Fed GDPNow model being revised upwards to suggest a solid 3% growth rate for Q3, there is no imminent need for aggressive easing and a 25bps cut appears to be the wiser choice.
But even if the Fed cuts by 50bps, the dot plot may not point to as many basis points worth of reductions as the market currently anticipates for 2024 and with no imminent signs of recession, Powell may justify a bold move by characterizing it as front loading.
All this suggests that it is very difficult for the Fed to match the market’s dovishness, implying upside risks that may lead to a stronger dollar and a rebound in Treasury yields.
How will Wall Street respond?
Equity traders were also careful ahead of today’s decision. The Nasdaq gained 0.20%, but both the S&P 500 and the Dow Jones finished yesterday’s session virtually unchanged.
Although it is straightforward how the dollar and Treasury yields will respond to a less dovish outcome, that is not the case with equities. Anything suggesting that a recession is out of discussion may allow investors to add to their risk exposure, even if the Committee lowers interest rates by less than expected and/or signals a smoother rate reduction path ahead.
Gold may pull back in the case of a less-dovish-than-expected Fed, but geopolitical tensions are likely to keep the slide limited and short lived. After all, even at a slower pace, lower interest rates tend to be a beneficial development for the zero-yielding metal.
Sticky UK inflation boosts pound ahead of BoE
Elsewhere, the pound rebounded today after the CPI data revealed that inflation in the UK remained sticky in August. The headline rate held steady at 2.2% y/y after rebounding from 2.0% in July, while the core rate remained elevated at 3.6% y/y.
This lowered even more the probability of a rate cut by the BoE tomorrow, which in contrast to some other major central banks, seems to be in no rush to cut further. There is a strong 75% chance for British policymakers to stand pat at this gathering.
The Bank of Japan is also expected to remain on hold on Friday, but instead of searching for rate cut clues, yen traders are trying to figure out when the next rate hike will be delivered.
by XM.com
