Fed Preview: How much are traders pricing in?

Markets have a bit of an awkward "eye of the storm" feeling to them today as traders continue to digest yesterday's ECB meeting.

As we noted in today's US FX Daily Update, the central bank opted to extend its Quantitative Easing (QE) program by 9 months but cut the monthly purchases from €80B/month to €60B/month effective in April. In aggregate, this represents €540B in asset purchases, more than the market had been expecting heading into the meeting (6 months of purchases at €80B/month = €480B). More to the point, ECB President Mario Draghi emphasized in his press conference that the purchases could be extended further if needed, making this a far more dovish decision than traders had expected.

The ECB's decision led to a predictably sharp bearish reaction in EUR/USD, which is trading down over 300 pips from its peak just over 24 hours. At this point, it looks like the world's most-traded currency pair has a date with previous support in the 1.0500 area next week.

Source: Faraday Research

The proverbial "eye of the market" will shift stateside to the US Federal Reserve's policy meeting next week, where a interest rate hike is all-but-inevitable. Nonetheless, the data in the accompanying Summary of Economic Projections and Dr. Yellen's press conference will determine whether the greenback sees a "Santa Rally" into the new year or not.

According to the CME's FedWatch tool, Fed funds futures traders are in disagreement about how many rate hikes to expect next year. The market-implied probability of a rate hike on Wednesday is 97.2%, but beyond that, traders don't know what to expect. Through the September 2017 meeting, the market is pricing about a 27% chance of no additional rate hikes, a 42% probability of one more rate hike, a 24% likelihood of two more increases, and a 7% chance of the Fed raising rates three or more time.

Next week's Fed meeting will go a long way toward shaping those expectations for the new year.as we see it, there are three potential scenarios that could play out.

1) If the central bank's "dot plot" and Dr. Yellen's press conference imply that the there will be only a single interest rate hike in 2017, the dollar will likely reverse its recent gains and fall sharply, while US equities could rally further.

2) If the Fed meets the market's expectations for about two interest rate hikes in 2017, markets may not see a big reaction and could merely consolidate into year-end, though there is a chance of a "buy the rumor, sell the news" reaction in the greenback.

3) If the Fed comes off as hawkish, hinting at the potential for three or more rate hikes (an unlikely development in our view), the dollar could rally further, with parity (1.00) potentially coming into play in EUR/USD, while US stocks may finally pull back.

Either way, traders of all stripes should be keeping a close eye on the Fed come Wednesday. Regardless, of what you're trading, you can't afford to ignore a highly-anticipated meeting from the world's most important central bank.