Fed June Preview: In the world we live in, a 50 bps hike is a dovish surprise

• The FOMC is expected to go off-script and hike by 75 bps in June.
• Markets fully price in another 75 bps rate increase in July.
• Investors will keep a close eye on FOMC Chairman Jerome Powell's comments on recession risks. 

The Reuters estimate shows that the US Federal Reserve is expected to hike its policy rate by 50 basis points to the range of 1.25%-1.5% in June. According to the latest market developments, however, such a decision would be seen as a dovish surprise.

Following the May inflation report, which revealed that the annual Consumer Price Index (CPI) climbed to a fresh multi-decade high of 8.6%, investors expect the US central bank to do what would be seen as unthinkable a few months ago - raising the policy rate by 75 bps. 

Goldman Sachs, TD Securities and Nomura are a few of the major financial institutions that announced on Tuesday that they revised their Fed forecasts to include 75 bps hikes in June and July. Reflecting the impact of rising hawkish bets on markets, the 2-year US Treasury bond yield rose nearly 10% on Monday and the benchmark 10-year US T-bond yield gained more than 6%. In turn, the US Dollar Index advanced to its highest level since December 2002 above 105.00. 

DXY daily chart

Dovish scenario

At this point, the initial market reaction to a 50 bps rate hike should trigger a dollar sell-off. In case the Fed opts for a 75 bps hike in June but rules out such action for July, the greenback could find it difficult to preserve its bullish momentum.

Another dovish scenario would be for the Fed to commit to two 75 bps rate hikes in the next two meetings and intend to take a break in September to assess the market conditions. FOMC Chairman Jerome Powell’s comments on the economic outlook will also be scrutinized by market participants. In case Powell acknowledges heightened risks of the US economy tipping into recession next year, investors could see that as a sign that the Fed might abandon its aggressive tightening stance.

Hawkish scenario

If the Fed hikes its policy rate by 75 bps in June and confirms another 75 bps hike in July, there could be a ‘buy the rumor sell the fact’ reaction initially. Nevertheless, such a decision should allow the dollar to continue to outperform its rivals in the medium term, especially the euro due to widening policy divergence with the European Central Bank (ECB). 

In case the policy statement reveals that policymakers discussed a 100 bps rate hike at this meeting or that they are willing to put that option on the table at the next meeting, it wouldn’t be surprising to see US yields and the DXY stretch higher.

Finally, if the Fed pledges to raise rates by at least 50 bps from September to bring inflation under control, there would be no reason for markets to start betting against the dollar.

Also read: Fed Preview: Powell to plunge markets or raise yields, a win-win for the dollar, five scenarios.