FOMC to signal caution ahead

USD: FOMC has reason for caution

The US dollar advanced yesterday with market participants expecting the FOMC meeting tonight to culminate in a 25bp rate cut. It’s fully priced and the focus will be entirely on the guidance of policy moves over the coming months. Retail sales data yesterday from the US was clearly good enough to reinforce investor expectations of US economic resilience continuing. Control Group retail sales increased a solid 0.4% m/m. If Control Group sales are unchanged in December, the Q/Q annualised rate increase is a strong 3.8%. It’s another piece of data that definitely is not entirely consistent with the need to cut rates tonight. In addition, the inflation data over the last four months has recorded a core m/m rate of increase of 0.3% - hardly evidence of price stability. The reality we believe is that politics will have played some role in this decision to cut tonight and if we were free of a new Trump administration coming in in January, the FOMC would probably have guided the market away from pricing a cut tonight. So the obvious offset to that is a guidance tonight that hints strongly at the idea of a pause to assess the impact of the 100bps of cuts since September.

Assuming a cut tonight, there is only about 3-4bps priced for a cut in January so the market is fully expecting a skip at that meeting, which comes the week after Trump’s inauguration on 20^th January. But pricing for a March cut has also declined gradually and is now close to a 50% probability. The stronger the hints tonight are on a pause the more the markets may consider the pause being longer than just one meeting.

The Summary of Economic Projections will include the updated dots profile and we expect the median dot for 2025 to drop from four to three. There is a small chance of a drop to just two dots but our base case view is a drop to three. That shouldn’t be particularly impactful and is largely expected so the market reaction will most likely be determined by the tone of Powell’s comments related to the signal of pausing. There is certainly justification for pausing given the data on consumer spending and inflation and the stronger this is signalled, the more market expectations of a March cut will diminish.

We also expect what the FOMC will describe as a technical change a cut to the ON RRP rate of 30bps in order to eliminate a 5bp spread that currently exists between that rate and the bottom bound of the federal funds rate. This change was signalled in the FOMC minutes in November and will likely be viewed as warranted given the SOFR has been drifting higher lately. SOFR has been more determined by the ON RRP and given year-end liquidity issues, the removal of this 5bps spread could help. The RRP is also dwindling in size with just USD 110bn (down from about USD 2.25trn) and removing the spread may take this down to zero – a possible precursor to the end of QT although we don’t expect that to be signalled tonight. The dollar is unlikely to be impacted by this decision with pricing on a March cut the more likely determinant of dollar moves. We see risks of US dollar strength as expectations of a cut in March could decline further post-announcements.

FED FUNDS, KEY RATES; BPS SPREADS FROM LOWER BOUND – SOFR DRIFTING HIGHER AGAIN

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Modestly softer CPI but yields to support pound

The pound continues to perform well in the FX markets and remains by some distance the second best performing G10 currency this year and is only marginally behind the top performing – the US dollar. The November CPI data has just been released in the UK and following the shock of the much stronger than expected wage data yesterday, there will be some relief in the rates market this morning with the CPI data marginally on the weaker side than expectations in relation to the core and services YoY gains.

Still, the headline rate did rebound as expected from 2.3% to 2.6%, the highest reading since August and does in fact confirm the first consecutive months of acceleration in the annual rate since the turn lower in inflation from the peak back in October 2022. The data does therefore provide justification for the caution on cutting rates.

There was some signs though that perhaps the upward inflation pressures in the services sector are beginning to abate. The 3mth change in services CPI was unchanged and could be an indication of softer inflationary pressures ahead although it remains too soon to make that call with conviction – there have been occasions during this post-covid inflation shock when the 3mth change has been around unchanged. Airline fares, a volatile component was one factor depressing transport inflation with a drop of 19.3% m/m and hence caution is justified. Nonetheless, airline fares usually fall in November but the 19.3% drop this year was the largest November drop since the monthly series began in 2001. The 0.1% m/m drop in services inflation was more than offset by the 0.3% m/m gain in goods inflation and nearly all of the overall headline 0.1% m/m increase came from alcohol & tobacco and clothing & footwear.

But overall there is no compelling information in this inflation data to suggest any change in expectations in regard to BoE policy expectations. The BoE’s own projections show a 2.4% expected increase in CPI in Q4 2024 and a 0.2% m/m increase in December would mean that forecast is realised.

So front-end rates are a little softer more on the relief after the wage data yesterday and won’t alter the expectations of a cautious BoE and a February rate cut is certainly not a certainty at this stage. Yields will remain supported and spreads will provide GBP with support. The 10-year Gilt-Bund yield spread hit a new record closing high yesterday which will continue to help strengthen the pound versus the euro.  

GBP/EUR AS GILT-BUND 10-YEAR YIELD SPREAD HITS NEW RECORD CLOSE

Source: Macrobond

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	09:00	ECB's Lane Speaks	--	--	--	!!
UK	09:30	House Price Index (YoY)	--	3.1%	2.9%	!
GE	09:30	German Buba President Nagel Speaks	--	--	--	!!
EC	10:00	Construction Output (MoM)	Oct	--	-0.10%	!
EC	10:00	Core HICP (MoM)	Nov	-0.6%	0.2%	!!
EC	10:00	Core HICP (YoY)	Nov	2.7%	2.7%	!!!
EC	10:00	HICP (YoY)	Nov	2.3%	2.0%	!!!
EC	10:00	HICP (MoM)	Nov	-0.3%	0.3%	!!
EC	10:00	HICP ex Energy & Food (YoY)	Nov	2.8%	2.7%	!
EC	10:00	HICP ex Energy and Food (MoM)	Nov	-0.4%	0.3%	!
UK	11:00	CBI Industrial Trends Orders	Dec	-22	-19	!!
US	12:00	MBA Mortgage Applications (WoW)	--	--	5.4%	!
US	13:30	Current Account	Q3	-286.0B	-266.8B	!!
US	13:30	Building Permits	Nov	1.430M	1.419M	!!
US	13:30	Housing Starts	Nov	1.350M	1.311M	!!
US	19:00	FOMC Economic Projections	--	--	--	!!!!!
US	19:00	FOMC Statement	--	--	--	!!!!!
US	19:00	Fed Interest Rate Decision	--	4.50%	4.75%	!!!!!
US	19:30	FOMC Press Conference	--	--	--	!!!!!

Source: Bloomberg