Expect Volatility Ahead: January Effect in Full Effect

MACRO MARKETS 

The much awaited FOMC meeting is on February 1^st. It has been almost 7 weeks since the last one, so there is some uncertainty going into this one. February and March will have 2 back to back meetings and the market is currently pricing in a 25bp hike at each of them.

The United States interest rate swaps market has been pricing in 48bps total, over the next 2 meetings. There is a small, but possible, chance of 8% according to the swaps market that the Fed will hike 25bps next week and then pause hikes.

The market and most analysts and economists are expecting 2 consecutive 25bp hikes with a potential for some hawkish guidance. There is also potential of Powell signaling towards a third hike, which would definitely crash the risk market quite a bit and reprice a lot of front end rates. This seems less likely, but it is definitely a possibility. At the same time it is quite possible that just like we get a potential third hike, we could have a second hike taken away. The base case scenario for me is two 25bp hikes and Powell giving neutral guidance with a slightly hawkish lean, leaning towards data dependency, which will put the focus of the markets back on payrolls and wage growth.

Traders have been positioning for this across various markets. According to Bloomberg,  front end rates traders have been hedging and setting up to fade the Fed guidance in the last few weeks. Traders in SOFR options have seen the buildup of a $40 million position that stands to benefit from around 25 bps of rate-hike premium being priced out of September 2023 futures. Other dovish scenarios include hedging against the possibility that the federal funds rate peaks well below the 5% level talked up by a number of Fed officials. Currently, the rate is 4.3%.

In my opinion, the most important thing to look out for is data over the next two months to see if there will be a May hike or not. A 25bp hike this next month and in March would be good for the fight against inflation. If they overdo it they have enough cushion, if needed, to cut the fall if growth and unemployment falter.