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Pause, Pivot, Hike

This evening’s US interest rate announcement remains the key event risk for this week.

Markets are currently pricing the likelihood of a 25 basis point interest rate hike at 87% (versus 97% for most of yesterday). The Fed’s job has become increasingly difficult over the last few months. Core inflation remains persistently high, with the bank’s preferred gauge, the PCE deflator, stating that prices rose 0.3% in April. However, further tightening to credit conditions could lead to further bank failures and significantly harm business and consumers. Former Treasury Secretary Larry Summers put the odds of US recession next year at 70%. The 10th of March brought with it the news of the Silicon Valley Bank’s liquidity issues and subsequent collapse, highlighting the stress caused by the current interest rate environment. On the same day, markets forecast US benchmark rates 1.5% lower by the 26/07/2023 FOMC Meeting (see chart below).

There’ll be little surprise if the Federal Reserve raise rates by 25 basis points, but the accompanying policy statement and forward guidance will be heavily scrutinised by investors. See below possible permutations.
1. Hawkish – The Fed ignore the prevailing market stress and increasingly vocal calls to curb interest rate hikes due to souring economic conditions. They reaffirm their commitment to bringing inflation back to target, or to pause only when real rates turn positive. Effect on USD – 2yr treasury yields would rise, the prospect of a July cut and perhaps a 2023 cut would diminish, and USD would likely gain ground.
2. Neutral – The Fed leave the door ajar for further rate hikes without expressly saying so. Effect on USD – Little change, treasury yields would climb marginally and mild dollar strength would result as markets evaluate the prospect of an additional rate hike over 2023.

3. Dovish – One and done, the Fed acknowledge continued stress in the banking sector and the wider economy, and will pause the current interest rate policy cycle, and only look to increase further should market conditions warrant additional hikes down the track. Effect on USD – 2yr yields would move back towards 4%, market expectations for rate cuts in 2023 would increase, and USD crosses would be increasingly sensitive to short-term economic data releases.

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