Will the Fed end 2022 with a bang or a fizzle?

The month of December is often a very big trading month. It’s the last month of the year and that brings with it a whole host of trading patterns we need to keep watch for. Firms can close up some/all positions to book year-end profits, and central banks issue their final monetary policy announcements for the year.

This year is no different as we have a lot to cram into one week. Here we look at what the Fed may have to do;

Still hiking and still pushing the narrative that the rate ceiling may need to go higher than at their last projections meeting in Sep. 

However, the pivoters, who have been fighting the Fed every step of the way, are gaining traction in calling the Fed’s bluff in the face of worsening data (see yields/USD).

This has recently been undermining the Fed message but it seems Powell doesn’t want to fight that. Why?

A bank survey recently showed that financial conditions have eased since the September FOMC, mainly down to the falling CPI numbers since then, and have been aided by Powell’s lack of fight against those easing conditions. Why is this important?

In simple terms,’Financial conditions’ are a measure at which markets and financial institutions ‘price’ interest rates into the real economy and this can help a central bank with its implementation of policy. For example, if mortgage lenders believe rates are going where the Fed says they are, they will act ahead of the projected rate hikes by raising mortgage product rates. If mortgage issuers think things are really hawkish, mortgage rates can move up steeper and faster. If they’re less hawkish, rates may move up more slowly and not as high. Using this example, we’ve seen US mortgage rates running right up to 7% fairly fast, and that sentiment plays into a tightening of financial conditions, which is what the Fed wants to see as those effects in mortgages can help take out some of the demand they want to see pulled from the economy. If this tightening effect becomes broad across the economy, the Fed can achieve a lot of their goals potentially without rates ever needing to get as high as they forecast. The market and the economy have effectively done their work for them.

But it’s never as simple as that. If financial conditions tighten too far in the Fed’s eyes, they risk demand dropping far faster and harder than they would like, and so some control is needed. This falls into the soft/hard landing scenario the Fed and others talk about. Given how it looks like the majority of the US economy is now looking softer, the Fed needs to make sure that the tightened financial conditions don’t accelerate a downturn, and that’s probably why Powell has seen fit not to fight too hard against the easing of financial conditions over the last couple of months. By not fighting the easing, he’s letting the market release some of the tightening pressure themselves, all while maintaining that rates are expected to keep rising. Where he was previously strict in fighting the pivoters to enforce the Fed’s tightening policy aims, he’s now happy simply to keep an ‘as you were’ attitude and let the market infer what it wants, for now. In that sense, he’s given the economy some small relief from hikes going into the New Year, without actually changing the Fed’s policy stance. This is the true power of central banks being able to control policy not just by what they do but also by what they say, or don’t say.

And so to the December FOMC. I, for one, have taken a lot longer than normal to put these pieces of the puzzle together. Maybe that’s down to my short USD bias and positioning clouding my view. I was expecting Powell to reinforce the Fed’s hawkishness at Brookings (if only for the reason of trying to get more shorts on at better levels). I think that’s still a risk for this FOMC because despite cooling the jets of tighter financial conditions, he won’t want to see much more of their tightening hard work undone more than necessary. So, there is still a risk that he now cools the jets of the more dovish side of the market. Just trying to find some equilibrium between too much financial tightening and easing could be the game for him at this meeting, which will then give the Fed a level playing field into 2023.

For trading the FOMC, it’s going to be about 2 things.

1. Confirmation of whether there’s going to be a new higher rate ceiling for 2023, how many Fed heads have moved that ceiling (the more there are the more hawkish it will look), and how long they expect that ceiling to last (see where the 2024/25 dots get positioned).
2. What Powell says now on policy. If it’s a repeat of the comments made at the last FOMC and Brookings, he may be sending a signal that some air still needs to come out of the financial conditions tyre. If he’s more stronger sounding on Fed rates, that would tell us that he’s given the easing all the rope it’s going to get.

For me, and trading it, I’m still going to be looking to get into some short USDJPY positions but I’m not expecting to see the pair running into the 140’s unless he’s super hawkish, or there’s some big year-end demand for USD. If it does though, I’ll looking to scale in shorts.

I’m currently long AUDUSD as part of my long-term view of USD so I have some exposure already. Whatever the Fed/Powell does and says (I’m not too interested in the hike increment discussion), the fundamentals are turning down but the last domino (jobs) is still standing strong. If that continues into 2023, and we see jobs turning lower, then the Fed will face a steepening hill to climb on convincing the market that rates will get as high as they expect, and the pivoters will be making their case for early cuts. In that scenario, yields and USD are going to come lower. 

If the data does start to look more rosier, if jobs remain strong and if inflation stops dropping and stays fairly hot, that will be a risk to my positioning as that will reinforce the Fed’s path for rates and may see them stay hawkish through 2023.

Any which way you look at it, this last meeting could be decisive for how the market sets itself up for 2023. It will be important to know the Fed’s view but more important to watch the price moves after, as any year-end moves may be out of sync with the Feds message but, therein lies just another possible trading opportunity, if one thinks the price moves aren’t matching the fundamentals or Fed message. To that end, make sure you understand all the moving parts before you attempt to trade it.

Ryan Littlestone