Surprise Fed Decision?

MACRO FRAME

The pause in military exchanges between the US and Iran could lead to more action on the diplomatic front, though the geopolitical risk premium in energy continues to support a hawkish macro backdrop.

STOCK INDEX FUTURES

Equity index futures were little mixed overnight, with the S&P and Nasdaq little changed, while the Dow gave up losses. Sentiment over AI infrastructure continues to dominate price direction ahead of today’s earnings from Meta and Microsoft after the Bell. Yesterday’s rout in semiconductor names was spurred by questions over how much AI chip leaders are effectively financing their own customers, given the recent report that Nvidia may offer OpenAI $250 billion of support for a data center project. Additionally, growing competition from China in the form of increased production capacity from Chinese memory makers and existing  low-cost, open-source AI models further increase risks to demand prospects for non-Chinese companies. Traditionally, Alphabet’s earnings last week would have been greeted with excitement, however, investor focus over AI buildout and further capex lead to shares declining sharply. That backdrop hangs over this week’s earnings, with focus less on revenue growth and more on returns generated from AI-expenditures. The reports  will also offer signals on demand for chips and other AI infrastructure.

Another swing factor is today’s FOMC decision. Although money markets are pricing a less-than-likely probability of a hike (36%), an increase in the Fed Funds rate should not be discounted. An earlier-than-expected rate hike would likely catch investors off-guard and pressure the tech sector, which has been increasingly rate-sensitive given the increase in borrowing to fund AI-infrastructure projects. Regardless of a rate hike at today’s meeting, we expect a hawkish reaction to the current environment from several Fed members.

CURRENCIES

US DOLLAR: The USD index was little changed overnight at 101.45 as investors largely await today’s Fed decision. Markets are fully priced for a rate hike in September and see a 36% chance of a hike at today’s meeting. However, given the current environment, a 25bp hike should not be discounted. The sustained move above the 100 level since mid-June continues to reflect market expectations that the Fed will hike rates this year, leaving price direction vulnerable to the divergence in policy expectations between Fed and ECB. Oil’s move lower on Tuesday eased yields and consequently the dollar, though no material solution to free up shipping in the Strait, or a realistic alternative is supportive enough to abate higher oil prices and inflation fears. Additionally, the escalation in hostilities overnight continues to offer the dollar a floor in the form of safe haven demand.

Watch point: While markets are not expecting any change in policy from the Fed, a hawkish outcome should not be discounted. Meanwhile, underlying fundamentals remain supportive of the dollar.

EURO: The euro is little changed at $1.1380, staying rangebound ahead of the Fed’s decision today. Oil prices rose sharply overnight following a US and Saudi strikes in Iraq and an intercepted Iranian missile attack on US forces. However, traders remained on the sidelines ahead of today’s policy decision. Just like the Fed, money markets in Europe have not significantly repriced ECB policy expectations amid the pause in fighting between the US and Iran given that the broader geopolitical and inflation risk backdrop remain hawkish. With no improvement in tanker flows through the Strait, in the event of a deal, the market will likely continue to price in risk premium, keeping European bond yields and policy tightening expectations elevated.

The ECB considers the current inflation shock to be medium-sized, which requires some policy action but not aggressive moves. It expects price growth to return to 2% in the next year. Slovak Central Bank Chief Kazimir said a rate hike at the September meeting is likely needed. Money markets are pricing a near 67% chance of a hike in September and remain fully priced in for a move higher in October. ECB President Lagarde has also made clear that renewed energy shocks make the case for a September hike more likely. Lagarde warned that the “full effects of the energy shock have yet to play out” and that earlier hopes of a benign scenario were unlikely.

Watch point: With the pause in fighting supportive in the near-term, broader price direction will be subject to Fed-ECB policy expectations.

BRITISH POUND: Sterling is little changed at $1.3282. Softer labor-market data has raised expectations that the Bank of England will hold rates steady on Thursday. The pound remains caught between rate hike expectations and questions surrounding the strength of the economy. Still, traders remain fully priced for a hike come November. With a fragile geopolitical backdrop, the pound remains vulnerable to a pullback toward $1.32. Investors reduced bearish bets on the sterling to around $4.64 billion this week, compared to an 11-year high of $8.72 billion at the end of June 22, according to the CFTC.

JAPANESE YEN: The yen is little changed at 163.82 yen per dollar. The possibility of a hawkish outcome at today’s Fed meeting could pressure the yen further against the dollar. Focus in week’s Bank of Japan meeting is likely to center around how strong or weak forward guidance from the bank is. Recent pressure on the yen has Policymakers will likely stay ambiguous about further moves, though a lack of a commitment to raising rates is expected to leave a bearish pressure on the currency. The timing of the next move could be pushed forward to September or October if the BoJ raises the risk of an inflation overshoot. Verbal efforts to support the yen have had little effect on the currency, and official intervention is unlikely to offer a durable rebound unless the Bank of Japan commits to raising rates quickly. Therefore, BoJ rate hike expectations will continue to be the dominant driver in yen direction, outside of the geopolitical bid. Prime Minister Takaichi’s government has retained language in its economic blueprint urging the BoJ to align with government policy, fueling worries that Tokyo might pressure the bank to slow further hikes.

Watch point: With the yen sustaining a break above the 160 level, intervention from the government appears to be the greatest near-term risk against further depreciation.

AUSTRALIAN DOLLAR: The Aussie is 0.46% lower to $0.6944. Second-quarter inflation in Australia came in below forecasts, which has prompted traders to reduce expectations of tightening from the Reserve Bank of Australia. The key trimmed mean measure of core inflation increased by 0.8% QoQ, below forecasts for 0.9%. The annual pace landed at 3.6% YoY, up from 3.5%, but below the RBA’s forecast of 3.8%. Markets are now see just a 3% chance of a hike next month, down from 21% earlier, and are pricing the chance of year-end hike at 50%.On Tuesday, RBA Governor Michele Bullock said underlying inflation remained too high and a further slowdown in domestic demand may be required to tame prices, though emphasized that the rate outlook remains uncertain as it was not yet clear whether the three rate hikes already delivered would be sufficient.

Watch point: While a durable end to the war would alleviate downside risks to growth and moderate inflation pressures, ongoing pass-through into broader prices is likely to be in focus in upcoming data.

TREASURY FUTURES

Yields inched higher across the curve in a flattening move. While today’s Fed decision is not expected to bring any change in policy, however we expect a hawkish voting result and that the risk of a move higher in the Fed Funds rate should not be discounted. The greatest indicator of a move upwards in  policy is the Two-year yield, which has risen 90 bps since the conflict between the US and Iran began, currently sitting over 50 bps above the upper bound of the current Fed Funds target rate.  The lack of flow of oil through the Strait continues to support upside risks in inflation and the current environment of higher-for-longer bond yields. Traders are now fully priced for a rate hike at the September meeting. A stable labor market has also supported the view that policymakers are expected to focus on taming inflation.

Watch point: Mainly, the prospect that inflation will remain sticky reinforces a hawkish backdrop for the Fed over the medium-term.

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