Will the Fed Add a Hawkish Flavor to a Smaller Hike?

With some Fed officials confirming investors’ view of a quarter-point rate hike, Wednesday’s FOMC meeting is likely to be among the highlights of the week. Market participants will want to find out if the consensus of policymakers also agrees with their view on the path of interest rates after the meeting, as this is where opinions diverge between the financial community and the Fed. What will the Fed signal and how does the market respond?

A bone of contention

At their last meeting for 2022, Fed officials raised interest rates by 50bps after four consecutive 75bps hikes. However, despite the smaller increase, they sang a hawk song, with the essence of the lyrics that interest rates may rise above 5%, while Fed Chair Powell’s solo part at the press conference intended to push back against pivotal expectations.

Since then, even if some policymakers have acknowledged that switching to a lower gear at the next meeting may be appropriate, most of them have adamantly stuck to their guns that interest rates are likely to rise to slightly above 5%, in line with the December “point. plot”, and that they will remain there for a prolonged period thereafter. However, this has been a bone of contention, as the market insists that interest rates are likely to rise to the 4.75-5.00% range, and that a 50bps hike in rates can be guaranteed by the end of the year.

Market keeps a gaze locked on data

It seems that investors are too dependent on economic data rather than the Fed communication, and especially on the steady cooling of inflation. In December, the headline CPI slowed for the sixth straight month, with the core rate also falling, confirming the view that inflation may be on a sustained low.

In addition, retail sales for December recorded their biggest drop in 12 months, a strong sign of worsening consumer demand that could lower inflation in the coming months, but also add to recession fears, especially after the ISM non- manufacturing PMI for December fell in. contraction territory for the first time since May 2020. Adding the further contraction in the manufacturing sector, a declining service sector (which represents about 77.6% of US GDP) is anything but encouraging. Yes, the preliminary S&P Global PMIs for January suggested some improvement, but still remained below the 50 boom or bust zone.

On Friday, after the Fed’s decision, the employment report for December is expected to reveal a slowdown in job gains, but with the unemployment rate remaining close to its five-decade low and wages accelerating, it would reflect a still tight labor market that may be the only argument in favor of the story of the Fed.

Dollar might win, but not out of the woods yet

Recent history has shown that market participants are willing to sell dollars aggressively when data improves their pivotal view, but they don’t buy with the same excitement when economic releases surprise to the upside.

Thus, even if the Fed continues to signal that interest rates are likely to rise above 5%, and even if Fed Chairman Powell pours more cold water on rate-cutting expectations at the press conference after the decision, the dollar is unlikely to explode. It could bounce back a bit and possibly extend its gains in the event of a solid NFP report, but with the first sign pointing to deeper economic wounds, investors may resume short positions. Therefore, dollar traders may pay even more attention to the ISM non-manufacturing PMI for January, which is scheduled to be released on Friday after the NFPs. Another month of contraction could well weigh on the dollar, while a bounce back above 50, as the forecast currently suggests, might prolong a possible corrective bounce for some time.

An overly hawkish ECB on Thursday, confirming expectations of more 50bps rate hikes beyond February, could also limit any dollar strength, as euro/dollar is by far the largest component of the index, with a 57.6% weighting.

The technical picture confirms that view

If this week’s agenda ends positive for the US dollar, EUR/USD could pull back and possibly retest the 1.0715-1.0800 zone as support. Even if it breaks below 1.0715, the pair would still trade above the uptrend line drawn by the September 9 low, which could keep the door open for a rebound.

If indeed the bulls regain control in the not-too-distant future and push the price back above 1.0800, they may push it up to the 1.1175 zone, defined as resistance from the March 31 high. That zone also acted as support between November 2021 and February 2022. For the EUR/USD outlook to be considered bearish, the bears may need to be strong enough to dive below 1.0215, as this is the move that could solidify a potential dip below the aforementioned uptrend line.