Four scenarios
The economic arguments have dropped into the background, and the game theory of today’s meeting is the more relevant discussion as the question is simply: Will Warsh get the committee onside for an inflation credibility rebuilding exercise that starts today? Or is this the same old Fed that promises inflation will definitely, for sure, totally be back to 2% in two years and keep rolling that “forecast”?
With the hike still priced in the 25%/30% area, but intellectual momentum building for a hike, the outcome where they go 25bps is a surprise but not a complete shock. Warsh sounded like he was on the warpath on June 17 and the weak data since then does not seem to have changed anything.
The metagame logic of hiking now is pretty clear, and any hike can be framed as a removal of the unnecessary and inflationary rate cuts in 2025. Not the start of a prolonged hiking cycle, but more an insurance hike or two (or three) to reset the market’s view of whether the FOMC actually cares about the inflation target. The closer the meeting gets, the more I feel they will probably hike today.
Let me go through how I think markets will react, because I do not expect completely orthodox reactions, especially in bonds.
Neutral/dovish hike. Even though this is not expected, this is my base case. They hike 25bps and signal this is insurance against bond market questions of Fed credibility. One or two more hikes are possible / probable, but full flexibility allows for the possibility of rate cuts quite soon after the hikes if economic conditions warrant this approach. Fully data dependent with no preset course.
Market reaction: USD rallies, stocks sell off, and bond market rallies huge. A move like this should be bullish the long end as it signals there’s a new sheriff in town and the old Fed policy of extend and pretend is over. There might be time to buy bonds after the hike because the kneejerk might be that bonds selloff briefly, but I prefer to go into the meeting long bonds for a short-term trade (long TMF). TMF is the Direxion Daily 20+ Year Treasury Bull 3x Shares, a leveraged ETF that seeks 300% of the daily performance of an index of US Treasury bonds with 20+ years to maturity (effectively 3x the daily move of TLT, which is its main underlying holding). It’s the zippiest bond ETF as you can see at right.
With no hike still the market’s base case, I don’t think TMF will get hit that hard if the Fed stays on hold, so there is a big asymmetry to the reaction function. I am putting long TMF with a stop at 31.69 in the sidebar.
If the Fed hikes today, it’s not your garden variety interest rate hike like 2022/2023. The economy is firing on just one cylinder these days as AI Capex and deficits are the dominant drivers of U.S. growth. The OBBBA buzz is gone now as its impact peaked already and the rate of change of capex growth has turned negative. The negative stock market reactions to increased capex, the flip to cash-flow negative at companies like Google, rising CDS that accompanies rising issuance, and physical limits to capex growth all put a lid on how much AI Capex can add to 2027 growth.
While my base case is the non-consensus dovish hike, the real base case, according to markets, is the hawkish hold. This is not a huge market mover, in theory, because we are exactly fully priced for a rate hike in September. This is definitely not a hawkish outcome for markets because it introduces the possibility of two huge batches of jobs and inflation data that could soften the Fed’s resolve. A lot can happen between now and September and no degree of hawkishness in the statement or presser will cancel out the fact that they didn’t have the courage to hike. This outcome should be small sell USD, buy gold, buy stocks, etc.
I have trouble envisioning the dovish hold scenario, but that’s the real mindbender given the market is taking Warsh at face value and most people I talk to believe that he is going to be different from his predecessors. This is an inflationary surprise for stocks, bonds, and gold. I would expect a large rally in tech on this outcome, and a decent rally in gold, too.
Finally, there’s the hawkish hike scenario, which I would rate as least likely. This would be a more open-ended hike that sounds like it could be the start of a more meaningful rate hike cycle where the terminal rate is judged to be significantly higher. Buy USD, sell stocks, sell gold and silver as this would signal that Warsh has the committee fully onside, including doves like Bowman, Williams, and Jefferson and confirms that Powell will ride the new wave inspired by Warsh.
AUD put
My AUD put is small ITM now and I have hedged 1/3 here at 0.6944. This gives some gamma through FOMC and then again through month end. I will try to detail my actions in real time as much as possible but of course I only publish once/day, so I reserve the right to change the hedging strategy based on FOMC today. CPI came in weak in Australia last night, which is hardly a surprise given all global CPI data has been coming in weak as economists’ models cannot properly calibrate the inflationary ups and downs unleashed by erratic and unpredictable U.S. military excursions.
Chart-wise, 0.6840/90 is the big support zone as a trendline and two horizontal support levels come in there. Regardless of the FOMC outcome, I will be covering the remaining delta down there somewhere in that 50-pip range unless we get the hawkish hike.
Final thoughts
The runup into the Fed has been textbook with the market positioning/hedging the scariest and most asymmetric outcome, a hike. The longer I trade, the more I believe that runups and human behavior prediction setups of this sort are much easier than trying to predict economies or policymaker actions or geopolitics.
My latest essay for Panoptica, called “Dear Ben”. My guess is you will love it or strongly dislike it.
CHF/JPY moving around but going nowhere so far and no real evidence of GPIF in the JPY yet. I remain hopeful.
