Fed Cheat Sheet: Three scenarios for EUR/USD price action as uncertainty is higher than usual

Will markets believe another hawkish cut? That may be the top question on the Federal Reserve's collective mind. The bank is set to cut interest rates for the third consecutive time but chances of a fourth move in December are low – that is what bond markets are telling us.

Background: Why the Fed is set to cut rates, reluctantly

The bank has two mandates – inflation and employment – which have gone in opposite directions. Consumer prices have been relatively subdued in recent months and years, but have recently picked up.

The Core Personal Consumer Expenditure (Core PCE) has advanced from 1.6% to 1.8%. This is the bank's preferred gauge of inflation and it is close to the 2% target – thus not justifying a rate cut. 

On the other hand, employment has shown some worrying signs of late. After years of gaining near 200,000 jobs per month, the labor market has had too many "one-offs" of weak figures. The most recent figure of 136,000 for September has already been acceptable– but in comparison to lower expectations. The drop in projections is in itself a source of worry.

Another development that keeps policymakers up at night is the recent slowdown in wage growth. After salaries finally topped the 3% annual rise mark, they slipped below this level in September. While the 2.9% increase may still be seen as a one-off – it may also be an ominous sign.

The broader economy has also been showing contradictory trends. The US consumer has been active and pulling the economy forward – but on its own. Forward-looking indicators are pointing to a manufacturing recession and investment is falling. The dismal Durable Goods Orders orders figures do not bode well for the medium term – the Fed's horizon.

What do Fed officials think?

James Bullard, President of the Saint Louis branch of the Federal Reserve, has been advocating for more stimulus and bold rate cuts. He dissented from the bank's decision in September as he wanted to slash rates by 50 basis points – double the standard cut. However, Bullard has seemed to let go in recent appearances. He is unlikely to vote against a cut but has stopped preaching for one. 

Other central bankers, including Jerome Powell, the Chair, have only said they will "act as appropriate." The last to speak before the Fed's quiet period was Richard Clarida, the Vice-Chair, and he did not stray away from the script. 

Pricing stood at an 80% chance of a cut at the time of Clarida's speech, his words, or lack thereof were interpreted as a nod to cutting rates, even though he refrained from explicitly endorsing a cut. However, the same bond markets are showing a low chance of another move – reflecting the Fed's stance.

So, a hawkish hike is on the cards. But Powell will have a heavy burden in explaining it once again. The Chair argued that July's first reduction was a mere "mid-cycle adjustment" and not a recession-style stimulus. He avoided that term in September's cut, but still remained calm about the prospects of that move. How will he explain it now? Or will he express concerns this time? 

Contrary to September, the Fed does not publish new interest rate forecasts this time. That means the Fed's statement and Powell's tone will make the difference. 

For EUR/USD, there are three clear scenarios:

1) Hawkish cut – EUR/USD retreats

In this scenario, the Federal Reserve cuts interest for the third time but insists that the broad economic outlook is upbeat and rejects another imminent cut. While Powell will likely struggle to explain the move, markets will likely accept it.

Investors tend to focus on the future and not the present – focusing on the "hawkish" rather than the "cut" – thus potentially pushing the US Dollar higher. As the move is priced in, EUR/USD's fall may be minimal. This scenario has a high probability. 

2) Dovish Cut – EUR/USD surges

If Powell will find it hard to explain why the Fed is unlikely to cut again, perhaps he has compelling arguments for the move – opening the door to further cuts. He may emphasize the GDP figures published earlier in the day – and are expected to show a slowdown – to express concerns. 

EUR/USD is set to soar on such Fed dovishness, which is not priced it. The probability is medium.

3) Shocking no-cut – EUR/USD crashes

The Fed never fully committed to this cut, and while a cut is priced in, the next move is in doubt. It is not impossible for the bank to pause at this juncture, perhaps soothing the message by opening the door to a December cut.

A change to the main scenario – the rate cut – would come as a shocker to markets and show the Fed is not keen on following their lead. The US Dollar will have room to rise in this low-probability scenario, sending EUR/USD plunging.

Conclusion

The world's most powerful central bank enters October's rate decision with a central scenario but with relatively high uncertainty as well. A hawkish cut is the most likely scenario and would be dollar-positive. However, a dovish cut and a shocking "no-change" cannot be ruled out.