The dollar index is rising, gold is retreating alongside stocks, as markets brace for the FOMC. Today, most traders and analysts expect a hawkish statement and/or a hawkish speech from Powell. Here are the key points to watch for in today’s FOMC: 

Inflation 

(Core PCE YoY) 

The progress on inflation has been stalling and appears to be anything but temporary. Over the last three reports, the core PCE has averaged a 0.36% monthly increase, equivalent to over 4% annually. With the waning base effect, if the current pace persists, inflation could be on the brink of a rebound. Members might need to acknowledge the possibility that this is more than just a temporary blip. 

Yesterday’s Employment Cost Index revealed that inflationary pressures from the job market haven’t abated. While some anticipate a slowdown in housing prices and rent increases to mitigate inflationary pressures, these effects seem to be limited. According to the FHFA House Price Index for February, house prices surged by 1.2% in just one month. 

However, first-quarter growth has shown signs of deceleration, this data supported by PMI data as well. Consequently, inflation might not rebound alongside slowing economic activity but rather plateau around 3%. In either scenario, the slowdown in disinflation is concerning, which is unlikely to please Fed members. 

Rate Cuts 

(2024 Rate Cut Pricing in Swap Market) 

At the March meeting, the Fed projected three cuts until the end of 2024, bringing rates to 4.75%. However, market expectations were significantly higher. At the beginning of the year, swap markets priced in 6 or 7 cuts for 2024, with the first cut to start at the March meeting. This optimism stemmed from rapidly slowing inflation. However, disinflation slowed month after month since the year began, leading to even more pessimistic market expectations than the Fed’s projection  with only one cut priced in until the year-end. This change was substantial. 

Though there will be no update of projections at this meeting, in the statement or at Powell’s press conference, Fed might hint that the scenario of three cuts could be winding down due to persistent inflation. If so, this could be interpreted as hawkish by the markets. 

QT (Quantitative Tightening) 

(FED Balance Sheet vs 10-Year Yield) 

The most significant dovish surprise could emerge from the discussion on Quantitative Tightening (QT). Several members have already indicated their support for slowing the pace of QT. The rationale behind this is to mitigate the adverse impact of QT on market liquidity and extend the duration of QT to further reduce the balance sheet. With elevated rates, persistent inflation, and substantial government spending, Treasury yields are trending upward, gradually approaching 5% once again. Simultaneously, liquidity in reverse-repo operations has diminished rapidly, raising concerns within the Fed. If liquidity dynamics deteriorate too swiftly, FED may need to intervene, potentially resulting in a balance sheet expansion akin to last year’s bank failures at best. 

The decision to slow down QT is not anticipated at today’s meeting but rather at the June meeting. However, if the Fed surprises the markets or if Powell clearly hints at such a move for June, it could be interpreted as dovish by market participants. 

Markets 

(S&P 500 – Dollar Index, Daily Chart) 

With rate cut expectations significantly trimmed and inflation persisting, the advance of stocks has stalled. The uptrend has been broken, and now a downtrend seems to be forming. AMD’s earnings report with a worse-than-expected AI outlook coupled with hawkish FED, might add to the downward pressure if we don’t see a breakout this week. Meanwhile, the dollar index is benefiting from additional support due to a weak Yen and the disparity in rate cut expectations between the Fed and ECB. 

(XAUUSD, Daily Chart) 

Meanwhile, gold has experienced heightened demand from central banks along with significant inflows from managed money. However, the overextended uptrend has been broken, likely shifting to a more realistic trajectory. While upward pressure on gold may persist over the medium to long term due to anticipated rate cuts, the timing and pace of these cuts may be delayed and slower. Consequently, this pressure might also be delayed and potentially lower. 

Conclusion 

The Fed will likely adopt a more hawkish stance today, given clear indications of persistent inflation. Any clear messages conveyed should be received by the markets, in contrast to earlier meetings this year when optimism overshadowed Fed warnings. We believe Powell and the rest of the members are content with recent market pricing of rate cuts but are displeased with the recent slowdown in disinflation progress. Traders may anticipate the dollar to remain strong in the coming weeks, with occasional minor corrections in the short term. The most significant dovish surprise might arise from the QT discussion today.