The market has become pretty confident about what to expect when the FOMC ends its two-day meeting tomorrow and announces its decision on monetary policy. The overwhelming consensus is that the Fed will keep rates unchanged, but pave the way for a rate cut at the next meeting. If that doesn’t happen, then there could be a strong move in the markets as it adjusts for the surprise.

The thing is, the markets and the Fed are once again on different pages about where interest rates should go. Granted, it’s been a couple of months since we’ve got a formal update on the FOMC’s view on the rate trajectory. Back then, the market and the Fed agreed. Since then, data has come out to convince the markets that there will be more easing than initially expected. This could be the set-up for another market shock.

The Changing Expectations

The issue at stake right now is what happens over the course of the next three months. That’s because the Fed takes a bit of a hiatus in August, so after tomorrow’s meeting, they don’t get together again until mid-September. 96% of the market expects the FOMC to keep policy unchanged at the end of the current meeting. But 100% expect the Fed to cut rates by at least 25 bps when it meets again in September.

The dissent here is interesting, because only 4% see a quarter point in July; 12% expect rates to be lower by 50 bps by September. That means there are 8% (or there is that much of a chance, according to the markets) of traders who think the Fed will cut by 50bps in September. Why would the Fed do that? Presumably because the economic situation has deteriorated enough to justify it, which would likely be read in the form of some kind of market crash.

What Could Disappoint the Markets

Considering these projections, the market is now pricing in three rate cuts for the rest of the year. The Fed hasn’t officially changed its stance on there being only one rate cut (presumably the September one) in the same period. Markets have been in the habit of expecting way more easing than the Fed actually delivers, and this could be another case where traders are getting too hopeful, too soon.

The consensus also seems to be that the market expects the Fed to lay the groundwork for a rate cut in September. That could be in the monetary policy statement that comes out when the decision is made, or in the phrasing used by Fed Chair Jerome Powell in his post-rate decision presser. Likely it would come in the form of dropping the oft-repeated until now “more data is needed” in order to conclude that easing is appropriate.

How the Reaction Could Unfold

The Fed could opt to stick to its narrative at the current meeting, and instead use the Jackson Hole Symposium, which is held in August, to telegraph the rate cut. This would mirror what happened two years ago when the Fed embarked on its rate hiking spree. That would likely leave the markets thinking the Fed is more hawkish, and maybe change the outlook on the number of cuts, boosting the dollar.

Stock markets would likely be unhappy. On the other hand, we have some important data coming very soon after, which is the July NFP on Friday. That could help reassure the market even if the Fed does give a surprise on Wednesday.

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