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2 trading scenarios for the Fed

Summary:

  • The FOMC decision is the key event this week. Decision will be announced on Wednesday 7pm BST (8pm CET) and conference will start 30 minutes later
  • Markets expect a "dovish hike" - interest rates hike but cautious statement, this could be a chance for the dollar
  • A significant dot-plot revision could send EURUSD above 1.13

The Fed’s decision is the most anticipated market even this week. It will be announced on Wednesday 7pm BST and Janet Yellen’s press conference will follow 30 minutes later. We analyse possible outcomes and present 2 trading scenarios.

A decision: hike discounted, questions about future moves

The Fed is broadly expected to increase rates for the second time this year and therefore such decision alone is not enough to make US dollar stronger. There are two issues that will be crucial for market reaction: a third hike later this year and balance sheet reduction. The US economy has been disappointing lately. The first quarter growth was low, inflation and wages decelerated and some business surveys softened. This could make the Fed more cautious but the US central bank nearly "promised" interest rate hike in June via multiple speeches and it is unlikely to back off. Markets want to know if the bank decides to increase rates once more in September or December and if it reduces bond holdings accumulated via the QE program. In our view a decision on balance sheet reduction could be delayed until September and while the Fed could prepare a bit more cautious statement, it will leave the door open for the third hike this year. This is a starting point for our scenarios.

Scenario 1 - GBPUSD

If the Fed increases interest rates and does not materially soften its rhetoric (Fed could say that economic weakness is temporary) the US dollar could end up stronger after the meeting. Yes, the hike has been fully discounted but  when we look at market interest rates, only one more hike is priced in until the end of 2018! That’s a very cautious approach - in March the Fed’s dot-plot communicated 4 more hikes (plus one in June). So if the Fed stays calm and Janet Yellen continues to see more hikes the dollar could gain. GBPUSD could be especially interesting in this scenario as the pound has been under pressure since the elections. The pair could head towards supports at 1.2550 and then 1.2360. 

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GBPUSD could decline to 1.2550 or below if the Fed points at more moves this year. Source: xStation5 

Scenario 2 - Gold

If the Fed does not increase rates (unlikely but possible) or becomes very cautious in terms of future moves gold prices could rebound after the latest correction. Gold prices test the key support zone just below $1260/oz and a "dovish" Fed (especially if there is no hike) could help gold return to upward trend with a target above $1300/oz.

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Gold prices test a key zone just below $1260. A cautious Fed could send prices higher. Source: xStation5 

For the advanced traders – Dot-plot analysis

A reaction to the FOMC meeting very often depends on nuances like changes in a dot-plot. This chart has been introduced by a former FOMC president and has each of the members placing a dot at a level where he’d see interest rates at the end of the next free years and a “longer term” (not specified but often compared to 10 year bond yields). Since then the chart has played a significant role in market expectations for interest rates and therefore any changes to it could have a pronounced impact on the US dollar.

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A significant downward revision to 2018 median could send EURUSD above 1.13. Source: xStation5 

We analyse how these changes have influenced the EURUSD in the first hour and four hours since the FOMC decision. Because it is impossible to analyse each individual dot we analyse changes to medians, understood as a sort of consensus at the FOMC. So let’s say if the median for 2017 was at 1.375% in March that means the Fed saw rates at this level at the end of the year (equal to 3 hikes this year). As we can see from a historical analysis these changes have been mostly negative (Fed members reduced their expectations for future hikes) and led to significant EURUSD increases over the first one and four hours. This was the case throughout 2015 and in March 2016. The only situation where EURUSD declined significantly was December 2016 and we can see why – the Fed not only raised rates but also raised expectations in the dot-chart.  

For this meeting we will focus on 2018 median as we do not think 2017 could change (even if Yellen is dovish the majority at the FOMC may stick to their “3 hikes scenario”). The 2018 median was 2.125% in March (3 hikes this year and 3 hikes in 2018). A revision of this median to 1.875% could be US-dollar negative but in our view (and given low market expectations) only a reduction to 1.625% could generate a strong EURUSD rally. This seems to be a low-probability event but should it occur EURUSD could rally above 1.13 within the first 4 hours after a decision. 

 

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