Markets are prepared for how Powell will answer this key interest rate question

How would you play two chess grandmasters simultaneously? It’s not that difficult, even for someone whose opening game never developed beyond 1.e4. You let one grandmaster play first, use their move against the second grandmaster, see their response, then use their move against the first grandmaster, and so on.

Likewise, investors are now at the point where they no longer have to understand what the Federal Reserve is going to do or what Chairman Jerome Powell will say, they just need to know what it will do, and he will say, compared to market expectations.

Like Ryan Paisey, market commentator at PriaspusIQ, put it: “Given how hawkish the vast majority of readings have been on today’s FOMC, there is a huge risk of disappointment. Powell, who appears neutral from a distance, will be viewed as dovish by many market participants. And if he should be dovish… Feathers will fly.

So let’s go through these possibilities, one by one.

Let’s rule out the accommodating possibility altogether. There’s a dovish argument to be made – the first quarter gross domestic product report may not have been as bad as the negative reading indicated, but the US economy is undeniably losing steam and consumer sentiment is in the toilet. Still, consumer prices jumped 8.5% year over year and the US labor market added 431,000 jobs last month. It would absolutely undermine everything Powell has done since November to start talking dovish now.

Moreover, even after a dismal April for both the stock market and the bond market, financial conditions have not tightened much. The Chicago Fed’s financial conditions index, for example, hasn’t even crossed zero yet. “As you know, politics works through financial conditions,” Powell told Bloomberg’s Rich Miller at the March press conference. “We need our policy to be transmitted to the real economy. And it does this through the financial terms, which means that as we tighten policy or remove accommodations so that they are at least less accommodative, the broader financial terms will also be less accommodative.

So expect Powell to brace the markets for multiple half-point rate increases ahead. But they already are – expectations are that the fed funds rate will be between 3.25% and 3.5% by next March, up from just 0.33% currently. That would be four consecutive half-point increases and then four more quarter-point increases.

A natural question, given that the Fed will likely have moved from a quarter point hike in March to a half point hike in May, is why not move to a 75 basis point hike in June. Tim Duy, chief US economist at SGH Macro Advisers, said a 75 basis point hike would be a bad move and risk the Fed not only looking panicked, but causing a recession. Communication would also become a challenge, as increases in these increases would quickly take rates to levels where the Fed would like to ease off, before economic data shows a significant slowdown in inflation.

On the one hand, Powell risks appearing too dovish by pushing back expectations by 75 basis points, and on the other hand, he may appear too hawkish if he says something like “all options are on the table.” Duy said the inverted yield curve story could come back into play if the market was convinced of a 75-point rally in June.

North American economists at Nomura, led by Aichi Amemiya, meanwhile expect increases of 75 points in June and July, although they don’t expect Powell to say so explicitly. “An answer that includes a reference to the 1994 tightening cycle, the last time the Fed raised rates by 75 basis points, would be a hawkish surprise, while a suggestion that 75 basis point hikes will not would likely not be appropriate would be accommodative to our expectations.That said, given that financial markets began pricing in a 75 basis point hike in June, we believe Powell has little incentive to play down the possibility of such a decision,” the team said.

The buzz

The Fed’s decision is at 2:00 p.m. Eastern Time, when it is expected to raise rates by 50 basis points and also announce its plan to sell bonds, and the Powell press conference is at 2:30 p.m. There is no dot plot this time around. Until then, nothing really matters, but ADP reported a 247,000 increase in private sector payrolls, while the Institute for Supply Management’s services index is due shortly after the opening.

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The steps

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