FOMC Set for 50bps Hike

A well-telegraphed 50-basis point rate hike at this week’s meeting means the focus will turn to the balance sheet runoff and the expected rate trajectory.

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What's moving

There is near-unanimous agreement that the Fed will hike rates by 50bps on Wednesday. The less than 1% of dissenters are calling for 75bps. Even Chairman Powell practically said that a "double" rate hike is to be expected, putting the FOMC on course for the harshest tightening since 1988.

With that sorted, the main focus is on the expected announcement of the pace for the reduction of the balance sheet. This is a more complicated issue. The Fed essentially doubled its holdings since the start of the pandemic, so is expected to take a much more aggressive move to reduce them than the last time around.

The key figures

During the last meeting, a reduction of about $60B in treasuries and $35B in MBS were discussed, for a total reduction of $95B a month. This compares to the 2018 Taper, where the Fed reduced purchases by $15B per month. It's also an issue of how much the Fed expects to "roll off", and whether the Fed will actively sell securities. Letting holdings mature and simply not buying more is likely to have less of a market impact than putting longer-term securities on the market.

How much of an impact this will have on the markets immediately is still an open question, however. The Fed's reverse repos are still near a record high, meaning the market still has significant "excess" cash. Meanwhile, the substantial selling of MBS could further disrupt the housing market, as the average mortgage rate has spiked to pre-pandemic levels.

After Bullard hinted at a 75bps hike in June, traders are also going to be scrutinizing commentary closely to see how fast the Fed is likely to keep raising rates going forward.

EUR/USD - ROC bullish divergence

The EUR/USD pair has fallen to $1.0475 in a viscous down-move and any attempts bulls have made so far to reverse prices do not show conviction. A bullish divergence appears on the ROC (14), but more downside is possible until price offers some validation. This means prices can slide lower while the bullish signal remains intact.

$1.0453 is a major multi-year support that could offer a relief if not a reversal – at least during the initial attempt. If its lost, $1.0350 becomes the next level for bears. Below the descending trendline on the chart, things are unlikely to turn bullish any time soon though.

Source: Spreadex trading platform

Key Takeaways

The Fed is expected to raise interest rates by 50bps, but the main focus is on the announcement of the pace at which policymakers opt to reduce their balance sheet.

The FOMC is debating a significant decrease in the money supply by selling off an average of $95B a month, compared to their $15B monthly tapering before. But the ramifications of that are not yet clear, with traders and investors expected to keep close watch on signals from the Fed as reverse repos sit near record highs.