How much does the dot plot matter for the USD?

As the FOMC meets later today, investors are bracing for a dovish shift in the monetary stance, as highlighted by our economists in “Fed to signal cuts are coming”.

The policy rate is widely expected to be kept on hold for now, so the focus will be on forward-looking indicators such as the dot projections. Every three months, FOMC members anonymously submit their forecasts about where they think the rates will be after three years. The median value of the projections is highly regarded by market participants as a tool to assess the timing and magnitude of the Fed’s monetary policy changes.

Given the aggressive market pricing for rate cuts in the last few months, dot projections will likely be the key variable in the markets’ reaction function.

Currently, the Fed's dot plot is forecasting one rate hike by the end of 2020, far from the nearly four cuts priced in the OIS curve. Starting from 2012, we analysed all the occasions where dot projections for the following year have been cut by the FOMC. The table below shows how the members reduced their policy expectations in relation to what the market was pricing before the meeting, along with the reaction in the FX market.

With the exception of the 2014 December meeting, the dollar index staged losses on the day of the meeting every time the FOMC cut the dot plot. In the G10 space, risk-sensitive currencies came up as the outperformers, with NOK leading the pack on three occasions.

Before the most recent dot update in March 2019, the spread between the dot projections and the OIS pricing for end-2020 was almost 100 bp. The Fed covered approximately half of the gap by updating the dots and the DXY sold off (-0.65% in the day). We suspect that during the meeting, the FOMC could readjust its dot plot by 75bp to the downside, changing their expectations for one rate hike to two cuts. This would likely be accompanied by a language indicating that the Fed is “closely monitoring the risk” and would pave the way for “insurance” rate cuts in the event of a fierce economic backlash from escalating trade tensions.

This would be the strongest downward revision since 2012 and would cover most of the current 120 bp of difference with the OIS pricing. The 1 year- 2 year segment of the curve would likely stay pressured and the DXY index could drop by 0.5-1.0% on the day. We have also included two other scenarios, each of which hints at different adjustments towards the end of 2020 dots and a different outcome for the USD.

If we are right with our call for the Fed 2020 dots to be cut 75bp, we think USD/NOK might lead the dollar lower (at least for the short term) in what should be a pre-emptive and reflationary move from the Fed. Even though a 25bp Norges Bank hike to 1.25% is priced in for tomorrow, we think tighter Norges Bank policy can keep the NOK supported and a dovish Fed could trigger a USD/NOK reversal to the 8.65 area.