Fed interest rate decision and Powell’s comments in focus

• Financial markets are hanging in the balance ahead of the Federal Reserve (Fed) interest rate decision
• Investors expect the Fed to keep interest rates unchanged
• Fed Chair Jerome Powell will have to strike a balance between continuing support and keeping inflation under control
• Pound Sterling (GBP) likely to remain volatile against the US dollar (USD) for the next 48 hours

The US dollar (USD) continues to make headway against a host of major currencies in mid-week trade, including the euro (EUR) and British pound (GBP).

At the time of writing, the British pound to US dollar (GBP/USD) exchange rate is trading flat at USD 1.3913, while the US dollar to euro (USD/EUR) cross is in a sideways range between EUR 0.839 and EUR 0.841.

Asian markets are also heading lower on Wednesday as investors cautiously await the Federal Reserve’s (Fed) interest rate decision and Federal Open Market Committee’s (FOMC) economic growth projections.

Most economists suspect Fed Chair Jerome Powell will attempt to strike a balance between providing continued support for the US economy without driving inflation higher.

Policymakers will also need to make sure they don’t express too much concern over rising yields, which have surged to record highs over the past month due to the US economy’s improved outlook.

Economic growth forecasts have been revised higher due to the USA’s accelerating vaccine rollout and the House approving President Joe Biden’s USD 1.9TN stimulus package, which is expected to boost US gross domestic product (GDP) by up to 4%.

However, expectations for a robust economic recovery from the pandemic-induced slump has caused investors to become increasingly concerned about the Fed’s interest rate decision, which has also impacted US dollar (USD) exchange rates.

The greenback has outperformed in recent weeks, and its near-term trajectory will ultimately depend on today’s interest rate decision, as well as the Fed’s inflation forecast, tolerance for rising yields and stance on future policy.

Investors have also raised bets that the Federal Reserve will increase interest rates earlier than previously indicated.

Federal Reserve interest rate decision expectations

The broad-based expectation across financial markets is that the Fed will pledge to hold interest rates between 0% – 0.25% and continue buying bonds at USD 120BN a month at today’s economic policy meeting.

However, investors are also interested in economic growth forecasts and unscripted comments from policymakers during the FOMC press conference – held 30 minutes after the policy statement and interest rate decision.

Last month, Fed Chair Jerome Powell cautioned that inflationary pressure is on the horizon but that the central bank will continue to maintain aggressive support and that inflation should not rise to a point where a tightening of policy would be warranted.

Still, Mr Powell has the formidable challenge of convincing financial markets that even if the status quo remains the same, monetary policy will remain unchanged. Investors will also be keen to see if his colleagues share that opinion.

Fed has the task of calming inflationary pressures

Rising inflation has become a real headache for the central bank. Even if Federal Reserve Chair Jerome Powell strikes a dovish tone, economists at MUFG Bank “see limited scope for a significant decline in yields over the near-term and risks for USD remain skewed to the upside.”

The Bank of America said today’s economic policy meeting would be “one of the most critical events for the Fed in some time.”

Meanwhile, Senior VP and Chief Fixed-Income Strategist for Charles Schwab, Kathy Jones, said today’s policy decision would be intriguing “because how do you upgrade your GDP forecasts to 7%, inflation target to 2% and unemployment forecast to 5% then say we’re going to be super easy.”

Kathy Jones said the Federal Reserve would likely “emphasize patience” today. She also expects interest rates to remain near zero, given that Jerome Powell recently said the central bank wouldn’t even consider raising interest rates until unemployment levels declined significantly.

At the same time, Bloomberg found that two-thirds of economists surveyed expected the FOMC to signal near-zero interest rates until 2023.

However, suppose the Fed fails to make its commitments to put a lid on rising yields and continue providing aggressive support prominent. In that case, Treasury yields could find further upward momentum, and investors could push the US dollar (USD) higher as a result.

Commerzbank currency analyst Antje Praefcke noted that contrasting commitments between the Fed and the European Central Bank (ECB), who had vowed to ramp up the bond-buying pace to contain rising yields, could also increase pressure on EUR/USD.

Eurozone’s laggard covid vaccine rollout and rising COVID-19 cases have also darkened the bloc’s recovery outlook, raising the prospect that the central bank will have to provide further liquidity to lift the economy out of the crisis.

Although the UK economy is expected to stage a solid economic rebound in Q2 2021, economic growth will likely be hindered by Brexit trade implications and conflict with the EU.

Although Britain’s rapid vaccine rollout will positively affect GDP for the upcoming quarters, JP Morgan notes that “it won’t impact the sustainable trend rate of growth, which is more relevant for the medium-term GBP forecasts.”

Pound Sterling outlook: Is more GBP/USD volatility in store?

The British pound (GBP) tumbled by 0.65% against the euro (EUR) and 0.5% against the US dollar (USD) on Tuesday before rebounding during New York trading hours to close higher against both currencies.

However, pound Sterling (GBP) struggles against the single currency and the greenback in mid-week trade amid a lack of positive news and economic data.

Société Générale Global Head of FX Strategy, Kit Juckes describes the UK currency’s recent performance as a “pre-MPC wobble” , and with little information to direct the narrative, investors are pricing in other variables.

Pound Sterling (GBP) could also endure further volatility in the run-up to Thursday’s Bank of England (BoE) monetary policy decision, albeit a sustained weakness is unlikely due to the UK economy’s improved outlook.

Furthermore, BoE Governor Andrew Bailey has been notably optimistic about the UK’s economic recovery prospects and financial markets are not expecting policymakers to change interest rates due to rising confidence.

With UK economic recovery on a firmer footing, coronavirus cases declining, and the vaccination rollout accelerating, the Monetary Policy Committee (MPC) could deliver a relatively hawkish statement tomorrow, which would be considered supportive of GBP/USD.

However, medium-term support for the British pound to dollar (GBP/USD) cross could be limited due to Brexit risks and trade uncertainty.

Thursday will be a busy day for GBP/USD traders and GBP/EUR bulls, although the British pound to euro (GBP/EUR) exchange rate is not expected to weaken from its current levels.

The British pound vs euro (GBP/EUR) pair is currently trading at EUR 1.1676. Given that UK economic growth forecasts and inflation targets are higher than the Eurozone, any weakness in GBP/EUR is unlikely to be enduring.