Here's what Australia's biggest bank thinks the Fed will do

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Will they or won’t they? It’s the question that has markets occupied ahead of what is likely to be the most important market event for markets not only this year, but for many years: the US FOMC September rate decision.

A coin toss, a line-ball decision on a knife’s edge – no matter what you call it, it’s going to be an incredibly close decision, one will almost certainly generate extreme amounts of market volatility no matter what decision the FOMC makes.

The foreign exchange and interest rates strategy team at CBA have done their homework before the event, producing a play-by-play guide to how they see it shaking out.

“What characterises this week’s FOMC meeting is the unusually large divergence in expectations between economists and market pricing”, the CBA team notes.

“A slim majority of US economists surveyed by Bloomberg expect the FOMC to increase the target range for the funds rate by 0.25% to 0.25- 0.50% this week. In stark contrast, the Fed Funds futures market is discounting only a 30% chance of a 25bps increase in the Funds rate this week, down from near 50% one month ago. The Fed Funds futures market is now only fully pricing a 0.25% increase in the target range by March 2016. That is six months later than currently expected by US economists. We believe the Fed will lift rates in December”.

Certainty has collapsed as a result of recent financial market volatility, and will ensure extreme market volatility as soon as the rates decision will be announced.

So what should markets be looking for when the FOMC releases its rate decision and updated financial market forecasts? According to CBA, there are four factors that will be influential.

  • Whether they increase or leave on hold the Fed Funds rate range
  • Its interest rate guidance for 2015
  • Its interest rate guidance for 2016 and
  • Its long run (or terminal) Funds rate guidance.

The evolution in the expected pathway for the Fed funds rate from FOMC members, along with current market pricing, is shown in the chat below.

Here’s CBA on what it expects the FOMC will deliver.

“Our base case scenario (60% probability) for the September FOMC meeting is the Fed: (i) leaves the Funds rate target range unchanged at 0.0-0.25%; (ii) cuts its interest rate guidance for 2015 from two hikes to one hike; (iii) cuts its interest rate guidance for 2016 from four hikes to three hikes; and (iv) cuts its long run interest rate guidance by 0.25% to 3.50% (upper middle panel in the table on page two)”.

And if this occurs, what do they believe will be the likely market reaction.

“In our base case scenario for the September meeting, we think there could be a knee-jerk dip in the USD and US rates as the close to 30% probability of a rate hike priced in for this week is removed and the Fed delivers a non-hawkish statement, reliant on the incoming economic data. But the USD and US rates should rebound because the FOMC should still be signalling a rate hike for late 2015 compared to current market pricing for an even slower tightening cycle. Overall, this would see intraday volatility lift, but the USD and US rates should remain in a range”.

In essence they expect the US dollar to weaken, US treasury yields decline (and in all likelihood stocks to rally), although they do not expect the moves to be sustained given the likelihood that the FOMC will still signal that interest rates are still likely to move higher later in the year.

Aside from the rate decision and updated projections for the pathway for the fed funds rate, CBA expects the FOMC’s updated economic forecasts will indicate a less aggressive interest rate tightening cycle than that previously offered in June.

“We think the FOMC’s updated economic forecasts will point to a more gradual policy tightening path. The consistent pattern over recent forecasting rounds has been for the FOMC to trim back its interest rate projections towards market pricing”, they note.

The FOMC will announce its September policy decision at 4am AEST Friday morning.

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