March 2022 FOMC Primer

Right... let's get to it. Wednesday will bring what will probably be the most important Fed meeting of the year. Sure, we all know that the Fed is going to do a 25bps hike, but the question is where do we go from there? 

The Fed's decisions are darkened by the prospects of economic uncertainty and high inflation.

Hopefully, Wednesday will bring some drama from Fed Chair Powell and we will finally get a better impression of where the Fed sees rates going, what the Ukraine crisis means in terms of uncertainty on Fed policy, and also an idea on the terminal rate / target balance sheet size for the Fed. 

All of this means, there is a huge amount which could affect the outlook for interest rate hikes in 2022. Currently, markets are pricing for 7 rate hikes this year according to Bloomberg. 

I have been very aggressive in recent months saying that this is overpriced, and that the reality is we will see closer to three hikes. I've already revised this once from the beginning of the year (where I expected two). I now change my 2022 forecasts once more, to 4 hikes. But that's it... unless the facts change dramatically, I reckon we will only see 4 hikes this year. (Notice how I've not mentioned the size of the hikes I expect to be enacted ;) ). 

It is useful to begin this primer with where the Fed was just three months ago at the December meeting. At that meeting, forecasts were updated and Fed officials provided their expectations for future policy in the form of "the dots" which are below.

Source: Fed - Summary of Economic Projections

As you can see, at the December meeting, the majority view was for US rates to end 2022 around 0.5-1%. What we will be interested to see is just how much higher these dots are going to be revised in light of the latest inflation data. 

To me, I suspect to see quite a substantial increase - probably with the median dot placed around 1.5%. However, remember that there is only one dot that really matters... and that is Powell's dot. We do not know where this is, but expect the market to take the initial report as a signal to move higher (at 18:00 GMT tomorrow), and then Powell to come out and stress the risks. 

Last thing on the dots... there is NO EVIDENCE WHATSOEVER that Fed policy plays out anywhere close to them, but the market thinks they are useful so there we are. They are just another forward guidance tool. 

The need to act: 

Everyone knows inflation is high, but so what... there is little the Fed can do to stem the surge in global commodity prices. Interest rate hikes will, of course, play into demand destruction. But when shortages are as acute as they are, only extreme volatility can perhaps curb some of the enthusiasm for commodity assets. 

The chart above though, is more concerning. It shows 5y5y inflation expectations (basically, the 5y expected rate in 5y time). These have been edging higher pretty rapidly, and the Fed is likely to be concerned. If longer term inflation expectations are above 2%, it is pretty likely that actual inflation will be above 2%. At some point, the Fed must act to bring inflation expectations down and restore confidence in the population that it has the situation under control.

How to trade the Fed: 

For me, this meeting will go much as the ECB meeting. First, we will see some hawkish policy statement released before the press conference. Then, the presso will start and the questions will pour in, Powell will stress the uncertainty around the outlook, throw in a few concerns about "demand destruction" and "uncertainty from global supply chain issues" and stress the Fed's willingness to "support the economy" should it be necessary. 

After an initial spike in the USD, I would expect to see a fairly quick and rapid reversal in the press conference. This is just my hypothesis, obviously if we get a dovish statement, then it could be the opposite where we see Powell hawk it up later. 

Either way, I suspect the overall effect will be for the USD to be unchanged, but for equities to stage a bit of a rally as I suspect it will always be less bad than the market expected. 

Basically, don't trade anything before the statement, then move the opposite way. 

THAT'S ALL FOLKS: 

That's really all I want to say on here... no doubt more thoughts will cross my mind before the meeting, so those will be going exclusively to email subscribers. Don't worry, it's free to sign up - just use the form at the top right!