US data roundup: CPI and a Fed meeting to round off the trading year

As we lead up to this week’s Federal Reserve meeting on Wednesday, the S&P 500 is warming up to the idea that the Fed will slow the pace of rate hikes. The S&P 500 rose by 1.3% at the start of the week, while the Nasdaq rose by 1%. US yields were relatively flat, with 2-year yields trading just below 4.4%. This has helped the US yield curve to recover a touch, although at -78 basis points, it is still at its most inverted since 1981. What is interesting is that the Federal Reserve rarely raises interest rates to the same level as the 2-year yield, yet the Fed is expected to do this on Wednesday, when the market is pricing in a near 75% chance of a 50bp rate hike to 4.25-4.5%. Rather than sit back and wait for confirmation from the Fed, investors are jumping on the trend of a slower pace of rate hikes, and stocks are rising. However, this enthusiasm has not spread to the dollar or the bond market, bond yields are static on Monday, and the dollar index is range bound around 105.00.

Why the dollar is range bound ahead of the Fed

In fairness, stocks tend to be the more capricious asset class, while bonds and FX tend to be more stable and more trend driven, respectively. The strong dollar trend of 2022: the dollar index has risen by 17% this year, is a hard habit to break. While we don’t think that the dollar index will reach the 114 highs from late September, unless there is a geopolitical event that spooks markets, we still think that investors will be shy to sell the dollar further from here. While the weaker dollar/ stronger euro story could be a key theme for 2023, we won’t kid ourselves by thinking that the Fed will give this pair a boost. After all, there is still a 25% chance that the Fed will hike rates by 75bps at this meeting, according to the CME Fedwatch tool. While that would be a surprise, it is somewhat baked in, which is protecting dollar downside for now. Added to this, the market tends to flail around at the start of the year, and it takes a while for a new trend to break through. Thus, DXY could be range bound, with the lower bound 105.00 for the next few weeks.

Two ways to prep for the Fed meeting

There are two schools of thought when it comes to the week’s FOMC meeting: 1, those focussed on the CPI report on Tuesday and 2, those who choose to focus on the Fed’s terminal rate. US CPI is expected to come in much softer on Tuesday. The market expects the annual headline rate of CPI growth to expand by 7.3%, down from 7.7%. The monthly rate is expected to rise by 0.3% from 0.4% in October. The core CPI rate is also expected to slow to 6.1% from 6.3% in October, with the monthly core rate expected to have grown by 0.3%, the same pace as October. This is a significant decrease. Look for the slower pace of housing, a key component of the US CPI. House prices have slowed sharply in the US this year, will that correspond with lower rent and mortgage costs, now that US mortgage rates look like they have peaked? This is worth watching, as without a decrease in the shelter/ housing component, it is hard to see how inflation can stay lower for longer.

Why weaker CPI change the tune of the FOMC meeting

As usual, we will also focus on the monthly rates, however, the market’s upbeat start to the week, suggests that they are certain that weaker price growth is on the cards. The question now is, will a weaker than expected CPI rate change the dial for the Fed? Could they sound less concerned about inflation and more worried about growth - a fear that is shared with investors?  Or will a stronger pace of inflation boost expectations for a 75bp rate hike? Thus, the FX and bond markets are right to be cautious until we get the CPI print on Tuesday.

The terminal rate: 5% or above?

The other school of thought ahead of this CPI meeting is that the focus should be on the Fed’s terminal rate, which may rise yet again. The Fed will release its dot plot on Wednesday, and while the market seems clear that the Fed will slow the pace of rate hikes, it is less certain about where the terminal rate will end up after Wednesday’s meeting. Ahead of this meeting, the terminal rate was expected around the 5% mark, however, if the dot plot suggests that this is substantially higher, say above 5.25%, then the market could interpret that as a hawkish signal, with higher short term bond yields, a more inverted yield curve and a stronger dollar; all of which are bad news for stocks. In contrast, a  terminal rate at 5% or below, could be seen a dovish signal, with the market anticipating that this hiking cycle is nearly over. If the latter happens, then the champagne corks could be popped and a fresh Santa rally for equities and bonds could be the on the cards. It could also herald a weaker dollar into year end.

Powell to tighten communications strategy

It is also worth watching the Fed press conference after the rate decision at 1930 GMT. Last time, Fed President Powell seemed upset when a journalist asked him whether he was happy that stock markets had started to move higher after the meeting, which caused the rally to reverse course. We expect chairman Powell to be more tight-lipped at this press conference, but it is worth following the press conference after the decision is announced. Overall, this is a dramatic way to finish the year, as we expect trading volumes to be substantially lighter by the end of this week.