The last Federal Reserve monetary policy meeting in 2018 is this Wednesday and investors are selling dollars ahead of what is widely expected to be the fourth rate hike this year. Contrary to popular belief, interest rate hikes are not always good for a currency. Over the past 2 years, the central bank's well timed moves helped to drive the economy forward, the dollar higher and allowed stocks to hit record highs.
However in the past 3 months, the trend has changed with equities, the greenback and the economy weakening. It started with concerns about the economy that spilled over to equities and onto currencies. At first, there were signs of slowing in the manufacturing sector, agriculture and housing. Then data worsened, the trade war intensified and investors grew concerned about the country's ability to maintain its 10-year expansion as the Fed continued to raise interest rates. Equities turned lower first and when Fed officials shared their concerns about growth the dollar and yields tumbled. While some investors are selling dollars ahead of the FOMC rate decision, others are waiting to see if Fed Chair Powell will emphasize the proximity of neutral rates over the need for additional tightening. The Fed currently sees 3 more rate hikes in 2019 and how the dollar reacts will largely hinge on whether that forecast changes.
Fed Chair Powell said interest rates are just below neutral last month but not all of his peers share this view and more importantly even if the Fed slows the pace of tightening, they could still be the only major central bank to raise interest rates next year. This possibility is one of the main reasons why some investors prefer to wait until after the FOMC rate decision to sell dollars.
When it comes to trading this month's Federal Reserve rate decision, there are a few things to consider. First and foremost, investors have fully priced in 25bp of tightening so a hike won't be a surprise. Secondly, most investors expect the central bank to be less hawkish so if the Fed makes it clear that further rate hikes are needed and there's still scope for 3 rounds of tightening, the dollar will soar regardless of Powell's concerns about the economy. Although the Fed forecasts 3 rate hikes, Fed fund futures are only pricing in 1 for next year and this huge misalignment will translate into FX volatility. If the Fed's dot plot forecast drops to 2 hikes from 3, the dollar will drop but the magnitude will depend on the Fed's tone. There's no reason for the Fed to talk up rate hikes right now because stocks are falling, yields are slipping and the dollar is weakening. Lower yields and a lower dollar also help to minimize the pain of falling stocks.
USD/JPY, which fell particularly hard today should test 112.40 pre-FOMC but a move below that level may not happen until after the rate decision. Taking a look at the table below, the economy is not doing as poorly as what is reflected by stocks and rate hike expectations and we know that the Fed wants to raise interest rates, just not as aggressively as they anticipated. So barring significant dovishness, any pullback in USD/JPY could be short-lived. Other currency pairs like EUR/USD and GBP/USD are a different story.