US Dollar and S&P 500 Could Take Diverging Paths After FOMC Decision

FED DECISION KEY POINTS:

• The Federal Reserve will announce its March monetary policy decision on Wednesday
• Markets expect the FOMC to deliver a 25 bp interest rate hike, but cautious policymakers may favor a pause in the face of rising systemic risks.
• A dovish Fed outcome will likely weigh on the U.S. dollar, while boosting the S&P 500 in the near term

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The Federal Reserve will hold its March monetary policy meeting this week and announce its decision on Wednesday. Expectations have been in flux following Fed Chair Powell’s hawkish testimony before Congress earlier this month and, more recently, the turmoil in the U.S. banking sector, but traders’ bets now lean in favor of a quarter-point rate rise according to the CME FedWatch Tool. A small-sized 25 bp hike will take the federal funds rate to a range of 4.75%-5.00%.

PROBABILITIES OF FOMC RATE MOVES

Source: CME FedWatch Tool

Before the FOMC blackout period began on March 11, guidance suggested that policymakers would plow ahead with their hiking cycle in the face of sticky inflation, currently sitting well above the 2.0% long-term target. However, the backdrop has changed dramatically over the past week to the point that the central bank may be forced to pause its tightening campaign sooner rather than later.

Any sudden shift in the policy outlook would respond to the recent stress in markets in the wake of the collapse of two mid-sized U.S. banks (SVB and SBNY). The crisis, which led the Federal Reserve to launch emergency liquidity measures to shore up confidence, has exposed banks’ vulnerabilities to rapidly rising borrowing costs and raised the possibility of a large and widespread “credit event”.

Although confidence appears to be improving following coordinated action by government authorities, the banking system remains in a vulnerable position. In recognition of this fragility, the Fed will be reluctant to rock the boat, fearing that additional tightening at a time of heightened uncertainty could reinforce systemic risks.

There is no doubt that controlling inflation is a key responsibility of the central bank, but preserving financial stability may be more important now. Policymakers probably also recognize that the banking sector tumult will likely have strong disinflationary effects. With many regional banks on life support, loan issuance will soon dry up as lending standards tighten, curtailing demand and depressing economic activity. This dynamic will help cool price pressures in the coming months.

All things considered, the stars appear to be aligning for a Fed pause, which will give policymakers more time to assess the situation and take stock of how tightening is rippling through the economy. Should this scenario play out, the U.S. dollar is likely to suffer heavy losses against its top peers, whereas the S&P 500 could manage to resume its recovery, as traders begin to position for a policy pivot. Any rebound in the equity space, however, could be temporary if recession headwinds intensify again.

FED FUNDS FUTURES, US DOLLAR & S&P 500 CHART

Source: TradingView