The Federal Reserve is set to raise the interest rate for the second time after the financial crisis, one year after the first, historic hike. That will not be a surprise and it is already baked into prices. The big question is what’s next? Traders will try to assess the FED’s path in 2017 in beyond. Will the FED react to Trump like markets did? Will they adopt a “wait and see” approach? Or will they see the glass half empty and go dovish? These are the three scenarios. Before tackling them, a bit of background. Second hike background When Fed Chair Janet Yellen and her colleagues raised rates in December 2015, their forecasts for rates, known as the “dot-plot” showed a central tendency of no less than four rate hikes in 2016. Since then, the economy has moved more slowly, especially in the early part of the year, so the rate hike was pushed back again and again. During the summer, a temporary scare in jobs growth was discarded as a blip, and growth had accelerated. Yellen was talking about a stronger case for a rate hike in September and the FOMC statement from November declared that the case was strengthening. Good jobs reports, especially that for October (published in November) which showed an acceleration in wage growth, cemented the hike. Another big event that happened in November was the election of Donald Trump as President. The initial shock lasted only a few hours. The pre-election narrative was that Trump would start trade wars, send stocks tumbling down and that the FED would wait for things to calm down. Chances for a rate hike dropped sharply only to rebound within hours, together with stocks. The new narrative is that Trump’s promises of stimulus would turn into reality, starting a virtuous growth cycle, especially as Republicans hold all branches of power. So, government spending and tax cuts would also push inflation higher and the FED will react with an accelerated path of rate hikes. FED tools and options The Federal Reserve can signal future policy via three tools this time. First, the regular statement can express a specific tone regarding the economy: the same as last time, more upbeat or more cautious. Here, they can acknowledge that inflation expectations are higher. Despite being just an acknowledgment of reality, mentioning this change could be dollar positive. The second tool is the set of forecasts. These consist of growth, employment, inflation and also the path of rates. The focus will be on the path of interest rates, especially for 2017, which currently projects two hikes next year. Any deviation will clearly be a big deal. Also, the inflation outlook should be eyed. The third tool is Janet Yellen’s press conference. She can emphasize or clarify any message the FED has, that was perhaps misunderstood. An initial market reaction to the statement and forecasts could be smoothed out or even reversed in her public appearance. Scenario #1: No rocking the boat This is the baseline scenario. It is important to stress that Trump is till President-Elect. He made many promises for his first day and first hundred days, but these are mere promises. Politicians don’t necessarily follow through and Trump also carried contradictory opinions on various issues. Stimulus can get out of control or be quite modest to non-existent. Nobody really knows, so why commit to anything? In this scenario, the statement is little changed, the dot-plot remains at two hikes for 2017, other forecasts are only marginally tinkered with and the statement could be summed with two words “data-dependent“. The dollar, which has enjoyed a broad rally, may retreat a bit on this non-news. Such a non-commitment will not be surprising, but will still allow for profit taking, especially for currencies that have recently fallen against the greenback. So, we could see EUR/USD rise and USD/JPY fall in this scenario, while GBP/USD and commodity currencies could wobble but not go anywhere fast. Scenario #2: Trumping Up In this scenario, the FED reacts to higher expectations of fiscal stimulus from President Trump, or at least higher inflation expectations. They also note the real improvement in the economy: ongoing job gains, better-sustained wage rises, higher consumer confidence and other upbeat figures Even without upgrading the dot-plot to three hikes in 2017, they can offer higher inflation projections, color the statement in rosy colors and Yellen could use the word “confidence,” repeating her stance from December 2015. In this scenario, the USD could rally across the board, with quicker moves in GBP/USD that had a nice run of late and also USD/CAD that ran on oil, could change course more strongly than others. Scenario #3: Dovishness defies The Donald In this scenario, the FED returns to its roots: dovishness. Janet Yellen and her predecessor Ben Bernanke led a dovish FED that prefers doing too much than not doing enough. Most FOMC members are dovish, voting overwhelmingly against some vocal hawks. They could take the recent rise in inflation expectations with a grain of salt, remain worried about future growth prospects expressing fear of the “New Normal,” low growth rate. They could point to November’s slide in wage growth as a warning that wage growth is not sustained. Another issue is the strength of the US dollar. The stronger exchange rate serves as tightening and could slow down the path of rate hikes. The case for being sensitive to the dollar is stronger with Trump threatening to label China as a currency manipulator. They could also cite international worries without getting too specific, especially without saying that Trump’s protectionist stance against China and Mexico risks the US economy. Yellen learned how to dodge political questions, but could still lash back at the person that wants her out by the end of her term. The dot-plot could remain unchanged, but with a negative tone, markets will easily be reminded that also last year, the FOMC projected four hikes and ends the year with just one. So, two projected hikes could mean none in 2017. In this scenario, the dollar could slide across the board, with the yen being the main beneficiary of such a gloomy scenario, enjoying safe haven flows. We may see a big profit-taking downwards move on USD/JPY. FED Conclusion The FED will raise rates in the one-year anniversary to the previous hike. The big question is the future. The most likely scenario is a “wait and see” approach. Ththe dollar could tick down slightly against the euro and the yen. The second scenario is an optimistic FED. The greenback could extend its gains, with GBP/USD and USD/CAD standing out. The third scenario is a very dovish FED and that would send the US dollar down, with the JPY standing out. What do you think? More: A Fed’s Hike This Week + 2 More Hikes In 2017 = USD/JPY At 120 – Nomura Yohay Elam Yohay Elam Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts. Yohay's Google Profile View All Post By Yohay Elam Opinions share Read Next USD: Fed’s Hike Fully In The Price – Danske Yohay Elam 6 years The Federal Reserve is set to raise the interest rate for the second time after the financial crisis, one year after the first, historic hike. That will not be a surprise and it is already baked into prices. The big question is what's next? Traders will try to assess the FED's path in 2017 in beyond. Will the FED react to Trump like markets did? Will they adopt a "wait and see" approach? Or will they see the glass half empty and go dovish? These are the three scenarios. Before tackling them, a bit of background. 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