Fed preview: Upward revision of 2019/20 interest rate forecast could yield USD rally

The Federal Open Markets Committee, under the leadership of Jerome Powell, is likely to raise interest rates by 25 basis points and reaffirm the plan to gradually reduce the size of its balance sheet.

Expectations are fairly high that Fed will likely revise higher the 2018 dot plots to four rate hikes. Many believe this will be a hawkish outcome, although the greenback says otherwise...

Dollar index weekly chart

Source: Netdania

The last three doji candles indicate the investors are not particularly impressed by the talk of possible upward revision of the 2018 interest rate forecast.

This is because faster Fed rate hikes in the short-term would only push the Fed closer to the ceiling - new normal or long-term neutral rate of 2.75 percent. (Back in 2012, the rate stood at 4.25 percent). Hence, the resulting rally in the greenback could turn out to be a bull trap. The dollar index may face rejection at the descending trendline resistance and resume the sell-off. 

However, the greenback will likely cut through the descending trendline resistance seen around 92.80 and test the 200-weke MA of 94.29 and the 10-year could break above 3 percent in a convincing manner, if the Fed pushes up its forecast of the long-term neutral rate (revises 2019/20 interest rate forecasts higher).

Also, investors could begin pricing-in a higher long-term neutral rate if the Fed focuses more on the inflationary impact of the trade wars.

Hawkish scenario

• Fed revises higher its 2019/20 rate forecasts and/or focuses more on the inflationary impact of the trade wars/US protectionist policies.
• Fed keeps long-term rate forecasts unchanged, but revises higher its 2018 dot plot to four rate hikes and mentions upside risks to inflation on account of trade wars, thus forcing markets to price-in the possibility of an upward revision of the neutral rate in the near future.

Dovish Scenario

• Fed revises higher the 2018 interest rate forecast to four rate hikes as expected and uses strong words to mention downside risks to GDP due to trade wars.
• Fed keeps 2018 interest rate forecast unchanged, uses strong words to mention downside risks to GDP due to trade wars.