special reports

FOMC Preview: How Are Markets Positioned for the Announcement?

Tuesday, 24 October 2006 23:44:42 GMT  |  David Rodriguez, Currency Analyst; John Kicklighter, Currency Analyst

FOMC Preview

See Attached PDF for more in-depth analysis

How are the Markets Positioned for FOMC?

Since Monday, the markets have been thinking about nothing other than tomorrow’s Federal Reserve monetary policy meeting.  Traders have already begun to position for it as they send the stock market, US dollar and bond yields higher.  Even though yields on the 10 year notes and December Eurodollar futures have been moving up significantly, Fed fund futures have not budged much, indicating that regardless of how the Fed sways, the key takeaway point is that interest rates will be left unchanged.  The stock and FX markets have not recognized this, but with both the Dow Jones Industrial Average and the EUR/USD at key levels, these markets may only have a limited reaction to a hawkish tone in the FOMC statement. 

What are the Fed’s options?

To answer this question, we look at what the Fed is not expected to do, which is to increase or decrease interest rates from its current level of 5.25 percent.  However what they could do is to change their assessment of the economy and price stability.  Even though recent economic data have been far from stellar, the details of the reports suggest that there is still enough underlying strength to keep the economy running.  In regards to price stability, core prices tend to lag headline prices and for the time being, core price inflation remains persistently strong.  Individual Fed Presidents have already raised concern about the high level of core rates, which suggests that the statement could make that view official.   Yet judging from the recent movements in the bond and currency markets, most traders have already priced this in, which raises the question of how much more the US dollar and yields can rise if the Fed really is hawkish.  The 1.2500 level in the EUR/USD and the 120 level in USD/JPY have proven to be tough barriers to break in many previous instances and unless the Fed is ultra hawkish, they could continue to hold.  The case for an ultra hawkish statement is weak as the strong earnings reports in the market as a whole mask the weakness in companies like Ford and Caterpillar.   Furthermore, sparking speculation of a return to rate hikes could be disastrous for the US consumers who are stretched thin on borrowed credit.  Therefore, we believe that traders have greatly overestimated the hawkish intent of the Fed.  At best the Central Bank is likely to keep rates steady in the next few quarters rather than raise them.

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