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The S&P just dropped close to 8% in 10 days and is on the brink of entering bear market territory. Is this time for the Federal Reserve to continue raising interest rates?
Growing optimism over the trade truce between China and the US, and cheaper valuations have not tempted traders back in to the markets. Hopes of a Santa rally are fading fast. A dovish hike or even a pause in US rate hikes could be the final piece of the puzzle investors have been waiting for.
The Federal Reserve will give their monetary policy announcement at 2pm E.T followed by an appearance from Jerome Powell at a press conference. The broad marker expectation has been for the Fed to lift rates for the fourth time this year. That said, there has been growing speculation that the recent market turmoil could prompt the Fed to not hike. The probability for a rate hike has fallen across the past fortnight and is now sitting at 71% according to the CME Fedwatch.
US economy still strong
We don’t think that the Fed will shelve December’s rate hike. US economic growth is robust at a solid 3.5% year on year in the third quarter, unemployment at 3.7% is at multidecade lows and inflation is running along slightly above the 2% target. Given the current health of the economy, the Fed would struggle to justify not hiking rates and failing to do so would send a panicky message to the markets. This could pull stocks lower still.
A dovish hike?
We believe the most likely scenario tomorrow will be a dovish rate hike by the Fed. Whilst we expect the Fed will give an upbeat assessment of US economic performance to date, they will highlight a less predictable data dependent outlook for 2019. The phrase “further gradual rises” that has accompanied the Fed throughout the year could be dropped as soon as tomorrow, allowing the Fed the freedom to press pause on the hiking cycle at will, potentially as soon as early next year.
The dot plot
The markets fascination over the Fed’s dot plot will be magnified tomorrow. Whilst the Fed’s dot plot points to three further hikes across 2019, traders are less convinced. We expect the Fed to lower this to two hikes. This would ease growing concerns in the market that the US economy will be unable to cope with much more tightening amid fears of slowing global economic growth.
Powell is expected to field questions covering the growing downside risks to the economy and the threat of an economic slowdown, particularly in light of the recent inversion of the yield curve.
The 25-basis point rate hike is more priced into the dollar than not; traders will be more interested in the outlook for 2019. As we expect this to be dovish hike, the dollar could fall on the realisation that the Fed may pause the hiking cycle or indeed end the hiking cycle much sooner than originally anticipated. In this scenario the USD/JPY could head back through 112.00.
Given the steep sell off in stocks over the past 10 days, traders will be paying close attention to the stock market reaction to the Fed’s plans. If traders consider that the Fed hasn’t sufficiently taken its foot off the accelerator, then stocks could continue falling. The market clearly doesn’t consider that the economy can handle the Fed pressing ahead at the current rate of monetary tightening.
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