The euro-dollar pair is attempting to develop a correction ahead of the announcement of the outcomes of the September meeting of the Federal Reserve. As the American session draws to a close on Wednesday, the Fed will announce its verdict, determining the fate of the greenback, at least in the medium term. This is the key event of this week and perhaps even the month, depending on whether the regulator presents a surprise of a "dovish" or "hawkish" nature. It's worth noting that there is no talk of a interest rate hike: any hypothetical scenario for the September meeting implies maintaining the status quo. According to the CME FedWatch Tool, the probability of a rate hike this month is currently 1%. Therefore, the probability of keeping the current policy parameters unchanged is 99%. As for the prospects of the November meeting, traders are still factoring in a certain percentage (30%) for a "hawkish" outcome.
The main intrigue of the September meeting is, in fact, the determination of the future prospects of the Fed's monetary policy tightening. The formal outcomes of the meeting have already been priced in and are unlikely to surprise anyone—unless, of course, the U.S. regulator repeats the move of its European counterparts, who unexpectedly raised rates last week. However, in my opinion, this is a highly unlikely scenario, as its implementation would trigger significant market turbulence. The Fed strives to avoid such situations, at least during Jerome Powell's tenure.
Therefore, traders' main focus will be on the remaining two meetings this year. As mentioned earlier, the probability of a 25-basis-point rate hike in November is 30%, and in December, it's 37% (assuming the status quo is maintained at the November meeting). In other words, the market estimates the chances of a 25-basis-point rate hike by the end of 2023 at roughly 40%. Following the September meeting, the probability of monetary policy tightening will either increase to around 60-70% or decrease to approximately 20%. It will all depend on the tone of the accompanying statement and Powell's rhetoric.
Until recently, all debates about the Fed's possible actions in the fall revolved around inflation: "hawks" pointed to the resurgence of overall inflation, while "doves" countered with consistent declines in core indices. At the moment, inflation remains a cornerstone of any discussion regarding the prospects of monetary policy tightening. However, now we must also consider another significant factor—the rise in the oil market. It is evident that this factor plays into the hands of the hawks, as the increase in the price of "black gold" will trigger a new phase of inflationary growth. This process is already underway; the question is how the Fed will react to the situation. This is the main intrigue of the September meeting.
Scenario #1: "Ultra-Hawkish"
The least likely scenario involves a 25-basis-point interest rate hike along with a veiled statement that this is the last hike in the current cycle. This is the path taken by the European Central Bank: contrary to expectations of maintaining the status quo, the regulator unexpectedly raised rates but did not announce further steps in this direction. The key message of the meeting was that the central bank would maintain the rate at the current level "for a sufficiently long time necessary to return inflation to the target level."
I'll repeat, this is the least likely scenario, but it cannot be completely ruled out, considering the ongoing rise in oil prices and overall inflation in the United States.
Scenario #2: Most Likely
The "base" scenario, in my view, involves maintaining the status quo while simultaneously tightening the rhetoric in the accompanying statement. Additionally, Fed Chair Powell may hint at a possible rate hike at the November meeting during the final press conference, "tying" this question to the dynamics of inflation growth in September/October. This scenario also assumes a more "hawkish" dot plot from the Fed, which will be updated on Wednesday. It will show that a majority of committee members favor one more rate hike by the end of the current year.
The implementation of such a scenario will provide significant support for the U.S. dollar, considering the relatively low probability of tightening monetary policy at both the November and December meetings.
Scenario #3: "Dovish"
The "dovish" scenario, in loose terms, involves maintaining the status quo while softening the language in the accompanying statement. It is essentially "Scenario #1" without the rate hike. The central bank may focus its attention on one hand, on the consistent decline in the core consumer price index, and on the other hand, on the slowdown in the Chinese economy and the rebalancing of the U.S. labor market. Within this scenario, the updated "dot plot" may reflect the central bank's intention to lower rates in 2024.
This scenario would exert significant pressure on the greenback. However, the probability of its implementation is quite low, once again, considering the current dynamics of the oil market and the prospects for further oil price growth. By the way, the Brent crude oil price has already reached $95 per barrel, and it seems that reaching the $100 mark is only a matter of time. It is evident that the rise in the price of "black gold" will further intensify inflationary pressures in the United States. Therefore, the Federal Reserve is unlikely to soften its stance (including verbally) in the face of such fundamental challenges.
Conclusions
Following the September meeting, the dollar may receive support from the Federal Reserve, as hawkish market expectations have recently weakened noticeably. Traders are not trapped in overly optimistic expectations, so more assertive language in the final statement will provide substantial support for the strengthening of the greenback.
It is also worth noting that the recent inflation reports in the United States were published during a "quiet period." How the central bank will react to the increase in the overall consumer price index and the producer price index (amidst the sharp rise in the oil market) remains an open question. In my view, traders largely underestimate these factors, so the possibility of a "hawkish surprise" from the Federal Reserve cannot be ruled out, primarily due to the market's somewhat subdued expectations.
