Market well prepared for a Fed hike

In recent days, leading into the FOMC meeting, high beta assets including emerging market currencies have rallied strongly to their best levels in most cases in over a month.  The market appears to have become well prepared for a Fed rate hike.  This strong market action suggests that there is interest in the wings waiting to buy the hope of a dip if the Fed proceed with a rate hike.

No rate hike will probably be more confusing to the market even though the Fed fund futures has the odds of a hike at less than 30%, as it might suggest to the market that the Fed is more worried about global economic conditions, and therefore it should be worried also.  It will not help reduce uncertainty and the kneejerk reaction to buy risk assets may fade quickly.

A hike combined with a continued claim that the pace of further hikes will be slow and calibrated to domestic economic trends and financial market conditions is likely to provide a relatively benign backdrop for investors that appear to be itching to get back into high beta investments after exiting over recent months.

The recent US economic data suggests that the Fed can proceed, the labour market is continuing to heal and is now close to full employment by some measures, and the housing market continues to reach new levels of strength.  There are some areas of weakness and risks but these probably matter more for the pace of policy tightening.

The UK labour market data showed further improvement, with higher wage growth, and the BoE made hawkish comments in testimony to parliament, suggesting that it remains on track to begin its policy rate hikes early next year.  As such, one might think that the BoE thinks that the Fed should begin its rate hikes this week as they have advertised much of the year.

My more positive assessment of risk appetite, combined with the more hawkish statements from the BoE, suggests there may be further downside for EUR/GBP.  It is still elevated by the risk aversion over recent months that boosted EUR as funding trades were unwound, and weakened the GBP as the market pushed back its assessment of when the BoE may hike rates.

If the Fed hike tonight, as I expect they will, it will increase the odds that the BoE follows early next year, and this should support the GBP.  If the Fed do not hike, it may tend to cause a kneejerk bounce in risk assets, which may also boost the GBP more than the EUR.  However, perhaps oddly, as discussed above, I see a more sustained pick-up in risk assets if the Fed proceed as long advertised and hike rates, helping lower uncertainty in the market.

So one strategy to consider is going into the FOMC tonight with a short EUR/GBP position.  It may perform regardless of the Fed decision. A risk to the trade is that UK retail sales are released ahead of the FOMC decision and if much weaker than expected they may detract from the GBP.