Policymakers are arguing that the recent surge in Treasury yields should be considered a hike, as the US economy continues to perform strongly. The Federal Reserve (Fed) is expected to keep interest rates unchanged, but may deliver a more hawkish message at its upcoming decision. The decision will take place on Wednesday at 18:00 GMT, followed by a press conference at 18:30 GMT.
The Fed policymakers have indicated that the increase in yields since their last meeting has achieved their desired tightening effect, potentially making another rate hike unnecessary. However, they have emphasized that in order for inflation to reach their target of 2%, interest rates will need to remain high for a significant period. Some policymakers have even suggested that additional rate increases may be necessary.
However, Minneapolis Fed President Neel Kashkari, who has previously been seen as a hawkish member, has acknowledged that if long-term yields are driven higher by expectations of Fed actions, the central bank may need to meet these expectations to maintain the desired yield levels. Fed Chair Powell has also acknowledged the role of rising yields, but has not ruled out additional actions.
Despite the Fed’s remarks, the US economy has shown resilience, with economic data suggesting robust performance. Headline inflation held steady at 3.7% y/y in September, against expectations of a slight decline. The employment report for the same month indicated a tight labor market. Additionally, the Q3 GDP data revealed a growth rate of 4.9% q/q, surpassing expectations. Preliminary PMI data for October also suggested a stronger-than-expected performance in the first month of Q4.
However, investors remain skeptical about the need for another rate hike, as Treasury yields continue to rally. Fed funds futures reflect a 30% probability of a 25bps hike by January, with expectations of around 80bps worth of rate cuts by the end of next year. The upcoming FOMC decision on Wednesday will be closely watched for any indications on the future path of interest rates. While it is unlikely that the Fed will take action, the statement and press conference may provide clues on whether the door for tightening remains open, and whether the market’s expectation of rate cuts is justified.
Considering the strong state of the US economy, there is a likelihood of a hawkish outcome. Even if officials do not hint at another rate increase, there is no economic justification for 80bps worth of rate cuts. Thus, there is a decent chance that Powell and other Fed officials may reiterate the view that interest rates may need to stay high for longer than the market expects in order to achieve their inflation objective.
In such a scenario, traders may revise their implied rate path, scaling back their expectations of rate cuts for next year. This could have a positive impact on the US dollar, especially when compared to the struggling European economy. Despite a recent rebound, the euro/dollar pair is likely to continue its downtrend, with investors already pricing in around 75bps worth of rate cuts by the European Central Bank. A hawkish Fed could encourage bearish sentiment, potentially leading to a breach of the October 3 low at 1.0445. A break below this level could extend the downward momentum towards the November 30, 2022 low at around 1.0290. On the upside, a move above 1.0665 would neutralize the outlook, while a breakthrough of the 1.1070 zone would signal a more positive picture for the pair.
