US economy on sound footing despite some wobbles
There have been a lot of worrying signs for the US economy lately. The unexpected resurgence in Covid infections due to the highly contagious Delta variant has knocked back both business and consumer sentiment over the summer, to the extent that jobs growth slowed substantially in August. In the meantime, there are some early indications that inflationary pressures may be cooling a bit. Both are strong grounds for the Fed to wait a little longer before reaching a decision on tapering.
However, although the economic data have been somewhat as unpredictable as the evolution of the virus path, there’s more than enough evidence to suggest that the American economy is far from being in trouble. The housing market is still booming, record job vacancies suggest the bumps in the jobs recovery are a supply problem not a demand one, and even consumers aren’t as gloomy as pointed out by some of the surveys, with retail spending growing solidly in August.
Tapering: almost there but not quite
So does this mean the Fed will announce a plan on Wednesday on how it will wind down its $120 billion monthly asset purchases? Probably not, but policymakers will very likely give strong hints that they’re getting very close to meeting their criterion to begin tapering and markets should expect a decision at the next meeting in November.
While this would mark a momentous point in the Fed’s own fight against the pandemic, the well-telegraphed move is unlikely to spark many fireworks in the markets. Investors will instead be focusing their attention on the updated economic projections, which of course include the famous dot plot chart.
Markets eyeing earlier rate hike
Back in June, FOMC participants had pencilled in the first post-pandemic rate hike for some time in 2023. But 2022 was a close call and it would only take three FOMC members to change their dots to bring forward the median prediction for a rate rise from 2023 to next year. Markets are already betting on an end of 2022 rate hike so such a signal would not lead to a huge repricing in fed fund futures.
Nevertheless, it would go a long way in confirming that tapering is definitely on the way whilst clarifying the Fed’s exit strategy from pandemic-era stimulus. The US dollar, which has been rebounding sharply from its early September lows, could stretch its gains if the Fed clearly flags taper action in November. Having just cracked above the 93.20 resistance, the dollar index could climb back towards its August peak of 93.73, before aiming for the 123.6% Fibonacci extension of the March-May downleg at 94.36.
A dovish Powell is dollar’s biggest risk
However, if the Fed does take a big step towards tapering but either the dot plot stays unchanged or the FOMC statement simply doesn’t deliver on the hawkish rhetoric, the dollar could come under selling pressure. The key support to the downside for the dollar index is the 50-day moving average just below 92.70, with the 61.8% Fibonacci of 91.95 being another critical level to watch.
Fresh jitters about the Chinese economy have added some uncertainty going into the meeting. But even if the fallout from the Evergrande crisis were to escalate, the Fed is already seen as being behind the inflation curve, so policymakers are unlikely to be able to delay tapering beyond the end of this year. A bigger risk for Wednesday is probably what Fed chief Jerome Powell says about inflation – whether he thinks it is levelling off, how worried he is about a slowdown in growth, and if he makes any remarks about the longer term outlook for US rates.