Currencies and equities have been consolidating ahead of Wednesday’s Federal Reserve monetary policy announcement. It is the most critical event risk of the week and the most likely catalyst for breakouts. With that said, U.S. retail sales will be released before FOMC, and the outcome will affect positioning before the rate decision.
Consumer spending plays a very important role in Fed policy, and a slowdown in spending amidst an Omicron scare could ease expectations for faster tightening next year. When Fed Chairman Jerome Powell said it was time to retire the term “transitory inflation” in the first week of December, he gave investors time to price in an earlier end to quantitative easing next year.
Now, investors are looking for answers to three questions from the December rate decision:
1. How much will the Fed taper per month?
2. How many rate hikes next year?
3. What are the growth and inflation forecasts?
Currently, the Fed is on pace to reduce asset purchases by $15 billion a month. We are looking for the Fed to double that amount to $25 billion-$30 billion. Anything less than that could send the U.S. dollar tumbling. The larger the monthly reduction, the more bullish for the U.S. dollar and bearish for stocks.
The last dot-plot was released in September, and at the time, only one rate hike was penciled in for next year. Nine out of 18 members predicted a rate hike in 2022. With inflation near a four-decade high, over half of U.S. policy-makers will favor a hike next year, and a growing number will be looking for 50bp of tightening. The U.S. dollar will trade sharply higher if more than half of the Fed sees two rate hikes next year.
The inflation forecast could be revised higher, but with growth peaking before Omicron, GDP predictions could be shaved lower, which would be bearish for the U.S. dollar.
We will also see how the Fed describes inflation going forward with the word "transitory" disappearing from the FOMC statement. The FOMC rate decision, dot-plot and economic projections will be released at 2 p.m. ET followed by Powell’s press conference at 2:30 p.m. ET.
As for trading the FOMC rate decision, there are three approaches.
The first – and probably riskiest way – is to position for more aggressive tightening by the Fed next year and take a trade before the announcement – getting out shortly thereafter. The initial move is often given back quickly as traders who took positions before the rake decision take profits after the initial release.
The second way to trade the FOMC decision is to wait about 30-45 minutes after Powell speaks, let the market make its final assessment, and buy or sell on the break of post-reaction high or low.
The third way is to simply stand down, wait for all of the dust to settle and trade at the Asia open.