Tomorrow’s FOMC press release is being eagerly anticipated by market participants, keen to see whether FOMC will provide more definitive guidance about whether Fed liftoff will start in September (most economists’ favoured date) or December (more consistent with market pricing). Despite such hopes, I suspect that the FOMC press release will likely contain only relatively minor language changes. FOMC will probably not see any need to disturb the status quo of market participants being clear that a 2015 rate hike is likely but FOMC having flexibility about its timing. Moreover, they will not want to add to current febrile financial market conditions. And that seems less likely to happen if they stick to the script they have been laying out i.e. the requirement to see further labour market improvements and be reasonably confident that inflation will move back to 2%.
More precisely, the June minutes’ statement that they will follow a meeting by meeting approach means that market pricing would likely shift more sharply if they suddenly substantially changed the language (i.e. switched from their clearly-signalled approach) than if they leave the language relatively unchanged. Indeed, one potential change is to add some “meeting by meeting” words to the press release. FOMC will also undoubtedly continue stressing that rates are likely to remain below normal for some time, but given that rate hikes are getting closer (as Yellen has told us) they could update the language to stress that “tightening shouldn’t be frightening”. There could also be some limited upgrades to the language on economic prospects to be more consistent with Yellen’s recent apparent optimism (although she also acknowledged that consumption had disappointed as consumers had saved the energy price windfall). But any such changes shouldn’t have major impacts given that Yellen has already said them.
And any such reactions will in any case likely be counterbalanced by the language on commodity prices being downgraded. The current “appear to have stabilized” seems lagging given the recent and relatively large falls in a range of commodity prices (oil, dairy, iron ore, copper, gold). But they will probably strive to not sound too dovish, by likely avoiding over-elaborating.
Relatedly, the charts below illustrate how US 5y5y breakevens have been surprisingly correlated with oil price movements over the past 18 months. And they have fallen back again with the latest oil price decline. Indeed, that recent fallback is a little more pronounced than for EA breakevens. And US breakevens’ correlation with WTI is a little stronger over the post-2014 period (0.97 versus 0.92). These findings are surprising given the meta-point that the price level impacts of oil price shifts should drop out of inflation calculations after a year and given that falling inflation expectations is generally thought to be more of a EA problem low inflation (provoking ECB QE). Of course, breakevens represent inflation compensation rather than underlying inflation expectations so can capture thinks like investors’ requited risk premia. And FOMC have placed less weight on them than the ECB. Nevertheless it is probably something for the FOMC to cogitate on. But I do not anticipate it provoking a change to the current “Market based measures of inflation compensation remain low” language.
And overall I would not anticipate a large USD reaction to the press release. And the risk-reward of near-term directional USD trades isn’t great given the number of moving parts in play and that ultimately only the FOMC know what they will do. But the risks are probably skewed to the recent risk aversion driven EURUSD bounce (see here) continuing near-term, given that some traders will probably not have fully bought the Fed’s “meeting by meeting” message and so will likely revise down US interest rate expectations somewhat. USD’s movements have been closely correlated with relative monetary policy expectations: the policy divergence FX market theme.