Will Jerome Powell spoil the bullish mood in the markets today?

European markets ended the first month of 2023 with decent gains, although recent momentum stalled in the last two weeks amid concerns that a brighter economic outlook could prompt a more aggressive monetary policy response Fed tonight and EBC Thursday.

US markets also caught their breath and had the best start to the year for the S&P500 since 2019. The Nasdaq 100 also enjoyed an excellent second half of the month, gaining 10,6%, and yesterday's strong finish could translate into the first hour of trading in Europe.

Projected rate hike of 25 bp

Judging by these January gains, it seems that US investors have made the decision that the Fed is to press the pause button today as it prepares to raise rates by the expected 25 bp. This will push the Fed Funds rate up to 4,5%-4,75%, which is still well below the level that several policy makers have consistently pushed for over the past few months, which is between 5% and 5,25%.

It is this disconnect between the Fed's rhetoric and what the market is pricing in that makes today's decision FOMC and Powell's press conference is a major event. We may find out how Powell combines the Fed's view of the path of future rate hikes with the markets' belief that the central bank will start cutting rates again before the end of the year.

While Fed officials insist rates will remain high for some time to come, markets just don't believe them, especially as several key inflation indicators have shown prices still steadily falling. Yesterday, the labor cost index for Q1 fell to 2021% and the lowest level since QXNUMX XNUMX.

This is what makes today's Powell press conference so important when it comes to market positioning. The danger for the Fed is to let the market continue to think that rates are likely to fall this year, which in turn could cause inflation to pick up again, especially with such a strong labor market as it is at the moment. Powell simply cannot afford financial conditions to loosen up and inflation to hit the economy again.

Narrative reset?

Something has to happen to reset the narrative - the market is pricing in a 25bp hike followed by a pause, although given the strength of the labor market, the Fed could surprise with a 50bp move, but that would be a surprise. Today is expected ADP report about employment in January will strengthen the position of the labor market, amounting to 180. people, compared to 235 thousand. in December. Data on wages will also be closely monitored, as in December they averaged 7,3%, and in the hotel and leisure industry wage growth amounted to as much as 10,1%.

We know that both Patrick Harker of the Philadelphia Fed and Lori Logan of the Dallas Fed said they would have no problem moving rates 25 basis points and they are both voting members of the FOMC this year while the Fed chairman Christopher Waller, which has tended to be hawkish in the past, echoed these views. On the other hand, we have Neel Kashkari of the Minneapolis Fed who said that the Fed funds rate needs to increase to 5,4% before the pause, so you can see there is a divergence of views.

This suggests that while there is growing favor in the committee to slow down the pace of rate hikes, differences may start to open as to where the policy should go, or differences may be only about the pace and not the target level. Nevertheless, recent calls for another slowdown in rate hikes helped to pull market expectations for a final rate below the Fed's target of 5% or higher.

With the Fed rate currently due to be raised from 4,25% to 4,5% and financial conditions relaxing, there is a risk that inflation could become a bit more sticky in the coming months unless the Fed resets market expectations. He may do so even if he raises the rate by 25 bp today, presenting hawkish hints and saying that more hikes are coming and rates will stay at current levels for some time. They could also increase the pace of balance sheet reduction, or QT, which is $95 billion a month. This number could be raised above $100 billion a month.

What volatility can you expect in the currency market?

Based on implied volatility from the overnight options market, investors seem to be pricing in that EUR/USD pair rate can move with 70 percent. +/- 148 pips by tomorrow, based on the spot price at 12:00 CET. USD/JPY, on the other hand, can have deviations of 180 pips, as well as the GBP/USD exchange rate.

It should be remembered, however, that the calculation of this volatility includes not only the Fed, but also the ECB Bank of England.