Fed Poised to Cut: Scissors or Axe?

• We see three rate cut scenarios: hawkish, moderately dovish, very dovish.

• UK inflation matches consensus and argues for a cautious BOE easing cycle.

• Inflation in Canada returns to the BOC’s 2% target for the first time since 2021.

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USD and Treasury yields bounced-off recent cyclical lows yesterday following encouraging US economic data. The increase in the August retail sales control group matched consensus and the previous month’s rise was revised a tick higher. Homebuilder confidence stabilized in September after slipping in August for a fourth straight month to its lowest point of the year. And August industrial production growth overshot expectations.

USD is back on the defensive ahead of the outcome of today’s FOMC rate decision (7:00pm London) and Fed Chair Jay Powell’s press conference (7:30pm London). The Fed funds rate is widely expected to be cut 25bps to a target range of 5.00-5.25%. The probability implied by Fed funds futures and the swaps curve of a 50bps rate cut are 68% and 57%, respectively. Meanwhile, just 9 of the 114 analysts polled by Bloomberg look for a 50bps.

Notwithstanding the “Powell wild card” and the FOMC vote spit, the three most likely scenarios today include:

(i) Hawkish cut. 25bps and the Dot Plots still indicating nine 25bps cuts through 2026 (same as the Fed’s March and June Dot Plots). In this scenario, a relief rally in USD would likely unfold underpinned by an upward adjustment to US interest rate expectations.

(ii) Moderately dovish cut. 50bps and the Dot Plots still indicating nine 25bps cuts through 2026, with most of the easing front-loaded in 2024 and 2025. In this scenario, USD has a kneejerk downside reaction as a jumbo rate cut is not fully priced in, but USD downside is limited because the Fed signals its easing cycle will remain more modest than market pricing (250bps of easing over the next 12 months).

(iii) Very dovish cut. 50bps and the Dot Plot plots indicating ten 25bps cuts through 2026, with most of the easing front-loaded in 2024 and 2025. In this scenario, USD would come under further broad-based downside pressure on narrowing bond yield spreads and improving financial market risk appetite.

We lean towards the first scenario because the US macro backdrop is in a good place. Economic growth remains robust, driven by strong consumption, the progress on inflation is encouraging, and a soft-landing in the labor market is underway. However, we acknowledge the risks are heavily skewed towards the dovish scenarios as the Fed may want to insure against a more pronounced labor market slowdown.

Specifically, we expect the 2024 Dot to drop from 5.125% to 4.625%, indicative of three 25bps cuts by year-end. The 2025 Dot will likely be adjusted lower by 75bps to 3.375%, indicative of five 25bps cuts. The 2026 Dot should remain unchanged at 3.125% implying one 25bps cut while the longer-term Dot stays at 2.75%.

We also anticipate the FOMC to make modest tweaks to its macroeconomic projections. 2024 real GDP growth will likely be lifted one tick to 2.2% in line with forward-looking indicators. 2024 unemployment rate forecast will likely be raised two ticks to 4.2% while 2024 PCE inflation should be adjusted one tick lower to 2.5%, reflecting recent data releases.

The vote for the monetary policy action will be worth monitoring. The last time there was a dissent at the FOMC was at the June 2022 meeting. Finally, the risk is high Powell delivers a dovish curve ball during the post meeting press conference because of the cooling in labor market conditions.

Ahead of the Fed, US August housing market data are due (1:30pm London). Building permits are expected to rise 1% m/m vs. -3.3% in July while housing starts are projected to increase 6.5% m/m vs. -6.8% in July. Overall, US housing market activity is a drag on the economy.

GBP had a modest kneejerk upside reaction after the UK August CPI printed in line with consensus. Headline CPI remained at 2.2% y/y, same as in July, core CPI rose two ticks to 3.6% y/y and services CPI increased to 5.6% y/y vs. 5.2% in July. Headline and services CPI inflation are tracking slightly above the BOE’s August forecast of 2.4% and 5.8%, respectively. However, the pick-up in services inflation reinforces the case for the BOE to pause easing tomorrow. Interest rate futures imply a small 25% probability of a 25bps cut.

USD/CAD remains range-bound around its 200-day moving average (1.3587). Slower inflation in Canada leaves the Bank of Canada (BOC) plenty of room to ease policy further. In August, annual headline CPI inflation hit the bank’s 2% target largely driven by lower gas prices while annual core CPI inflation (average of trim and median) eased to a 40-month low at 2.35%.

BOC Senior Deputy Governor Carolyn Rogers cautioned that while inflation slowing to 2% is good news, “there’s still work to do.” However, with both headline and core inflation tracking below the BOC’s Q3 projections (2.3% and 2.5%, respectively), an outsized BOC policy rate cut at the upcoming October 23 meeting cannot be ruled out. The swaps market price-in about 50% odds of a 50bps cut.

Bank of Canada releases the September meeting Summary of Deliberations (6:30pm London). At that meeting, the BOC delivered on expectations and cut the policy rate for a third straight time by 25bps to 4.25%. The BOC also reiterated “If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further cuts in our policy rate.”

NZD/USD is a little firmer just under 0.6200. New Zealand’s annual current account deficit printed at -6.7% of GDP in Q2 same as in Q1 and up from a low of -9.4% of GDP in Q4 2022. Nevertheless, the current account deficit remains large by historical standards, suggesting NZD needs to keep trading at a discount to fundamental equilibrium to attract foreign investments and finance this deficit. We estimate long-term fundamental equilibrium for NZD/USD at 0.6610.

New Zealand’s Q2 GDP report is the next domestic data highlight (11:45pm London). Real GDP is expected to fall -0.4% q/q vs. +0.2% in Q1. The RBNZ has pencilled-in a -0.5% decline. A deeper downturn in New Zealand economic activity can raise the likelihood for another 100bps of RBNZ policy rate cuts by year-end and weigh on NZD.

Indonesia and Brazil’s central banks hold policy-setting meetings today. Bank Indonesia is expected to keep rates steady at 6.25% and BCB is expected to hike rates 25bps to 10.75%. Check-out our detailed preview here.