FOMC primer: Policy divergence – Dead or Alive?

From the FXWW Chatroom – As previously noted (September FOMC/USD risks have shifted), the September Fed remains a closer call with economists than with the bond market. Futures forecast about a 20% probability the Fed will raise interest rates on Thursday. Citi’s baseline is for a 25bps hike (link), but there remains considerable scope for surprise, as well as shifting communication to play a role. Ultimately we think the decision boils down to how the FOMC sees market conditions, and whether the recent volatility could lead the FOMC to temporarily postpone hiking. In our view we place a 25% chance of a hike, and 75% for no hike. Still, the risk/reward favors a more hawkish outcome. We think the next most likely possibility would be for the committee to signal the October meeting as live, a hawkish outcome for the bond market. 
These are the options as we see them from most hawkish to least and our current subjective probabilities on each: 

1.     25bps hike, reaffirm data dependence with emphasis on domestic developments, EM a risk but not likely to derail US economy and financial markets. This would open up a further hike in 2015 if data keep coming in as strongly as they have (5%). 
2.     Dovish hike, convey that next hike is contingent both on US economic data and global financial/economic stability (20%). 
3.     No hike, but convey that they are very close and clearly point to October as live (20%). 
4.     No hike, but hope and expect one 2015 hike contingent on global situation and US economy (30%). 
5.     No hike, emphasize the downside risks, headwinds and leave timing very open (15%). 
6.     Imply that 2015 hike is off the calendar (10%). 
Impact on markets: Buy USDCAD on hike, Buy AUDJPY on unchanged 
If September hike – Buy USDCAD 
Initial reaction is clearly USD positive through the rates channel. Distance on USD rally depends on how market extrapolates the tightening path (after SEP/Yellen signals). More hawkish outcomes (i.e. unch dots) counterintuitively could have a negative impact on USDJPY, working more through the risk channel. This is because more aggressive rates scenarios could squeeze EM growth, even if later prompting a BoJ response. 
EM could still survive a rate hike should communication be sufficiently dovish, but prospects don’t look great with the scenarios where the Fed hikes potentially light on firm guidance. For sure, language on gradual tightening is likely to stay but anything more prescriptive seems unlikely. Signals that the next hike is expected only when inflation is much closer to target could fit the dovish profile and get away from the calendar. 

We like USDCAD higher under a Fed hike, signaling a more hawkish reaction function, supporting the yield differential and dampening the external demand impulse to Canada. To the extent that EM faces renewed pressure, oil prices could also act as a drag on CAD. 
If September skipped – Buy AUDJPY 
If September is skipped, the reaction in FX is going to depend on the motivation. If it was market volatility, EM uncertainty and the USD, then October is more likely to be in play. Instead, if its inflation and a view the NAIRU is considerably lower, 2015 could be off the table. Both scenarios indicate more dovish reaction functions, should support risk, steepen the yield curve and boost JPY crosses. 
Calling a press conference for October and giving it a high probability for liftoff would be a USD positive given hikes are only fully priced closer to December. This is likely to be felt most against low yielders with activist monetary policy (EUR, JPY, CHF). This scenario could limit the scope for EM to outperform but would give the market a semblance of Fed put. Indeed, should the FOMC tie the chance of an October liftoff to the state of global markets, EM could at least slow in its descent with an implicit stabilization mechanism. 
Signaling December or uncertainty on 2015 would be the most USD negative/risk positive outcome. This could come through the form of moving the NAIRU (last 5.1%) and adjusting down the view on terminal rates. USD underperformance will be broad and majors will face appreciation pressure. Such a shift raises probabilities on easier ECB/BoJ policy. 
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