The Federal Reserve and the European Central Bank are here this week to prove us wrong.

The year-end drama of the central bank is about to begin, and the "Super Thursday" with the leadership of the Federal Reserve is coming!

On Wednesday, December 13th, at 2:00 pm Eastern Time (Thursday, December 14th, 3:00 am Beijing Time), the Federal Reserve will announce its final interest rate decision of the year, followed by a press conference by Federal Reserve Chairman Powell on monetary policy.

Major Wall Street investment banks unanimously believe that the Federal Reserve will continue to hold steady and maintain interest rates for the third consecutive time. For this meeting, the focus of the market's attention will be on the Federal Reserve's last quarterly economic outlook, SEP, and dot plot for the year, which will be an important clue for the outside world to evaluate the future policy path of the Federal Reserve.

At the September interest rate meeting, the Federal Reserve's judgment on the terminal interest rates for 2023 and 2024 was 5.6% and 5.1% respectively (implying one rate hike in 2023 and two rate cuts in 2024), which was more hawkish than the four rate cuts expected by the market before the June meeting, causing significant market volatility.

Prior to this meeting, market sentiment is more optimistic. According to the latest CME Federal Reserve Watch data, the probability of the Federal Reserve maintaining interest rates in the range of 5.25%-5.50% in December is 98.4% , and the market is currently betting that the Federal Reserve will cut interest rates five times totaling 125 basis points in 2024, with the earliest action starting in May next year.

There is a difference of nearly 100 basis points between the pricing of the interest rate market and the Federal Reserve's dot plot in September for the judgment of the year-end interest rate, so how should the "contradiction" between the Federal Reserve and the market be reconciled?

18 hours after the Federal Reserve announces its interest rate decision, the European Central Bank will also stage its last "performance" for 2023.

The current situation of the European Central Bank is quite similar to that of the Federal Reserve - inflation data is also rapidly falling, and market expectations for a rate cut by the European Central Bank next year continue to rise, but the European Central Bank has not yet made any statements.

It is widely believed that the European Central Bank will also not take any substantive action at the last meeting of the year. On the one hand, this is because the inflation rate in the eurozone has reached its lowest growth rate in 28 months at 2.4%, and on the other hand, European economic data is generally weak.

The currency market has fully absorbed the expectation that the European Central Bank will cut interest rates six times, a total of 150 basis points, in 2024, which will bring the key interest rate in the eurozone down to 2.5% in 2024, and it is expected that the European Central Bank will start a rate cut cycle in April next year.

Federal Reserve: How will the year-end drama unfold?

It is almost universally believed that this round of interest rate hikes has come to an end, and the Federal Reserve may hold steady in this week's interest rate decision and then significantly cut interest rates starting next year. The focus of debate on Wall Street has now shifted to: When will the Federal Reserve start cutting interest rates, and how much will the rate cuts be?Despite the median projection in the September dot plot suggesting that the Fed will raise rates by the end of 2023 and cut rates by 50 basis points in 2024, the market is now betting that by the end of next year, the federal funds rate will be lowered to a range of 4%-4.25%, with a rate cut of 125 basis points.

Key Point 1: How to reconcile the huge divergence between the Fed and the market?

Against the backdrop of stubborn core inflation and a still hot job market in November, the market has only slightly lowered its expectations for Fed rate cuts next year to about 108 basis points, which is far from the Fed's current rate cut expectations.

According to Jonathan Millar, former economist at the Fed's Research and Statistics Division and now senior U.S. economist at Barclays, the market's current expectations are too optimistic. The Fed continues to emphasize that rates will remain high in the long term, so he believes that the rate cut cycle will not officially begin until the end of next year, with only a 25 basis point rate cut at the end of next year.

Chris Harvey, strategist at Wells Fargo, warned in an interview yesterday that the market's optimism has gone too far:

We expect Fed Chairman Powell to try to convince the market that there will be no policy easing in the short term, but we doubt whether market participants will believe the Fed's remarks again and reduce their bets on rate cuts next year.

Analysts believe that the market's judgment on whether the Fed is hawkish or dovish will focus on the update of the "dot plot".

Michael Gapen, chief U.S. economist at Bank of America, expects the dot plot to show that the rate cut expectation for 2024 will be 75-100 basis points, lower than the market's current expectation of 108 basis points. However, since the start of this rate hike cycle, market expectations have consistently been more dovish than the Fed's SEP, so even if the rate cut in December's SEP is lower than market expectations, it may not have a significant impact on the market.

Goldman Sachs and Wells Fargo believe that the median interest rate for 2024 will be lowered from 5.125% in September to 4.875%, equivalent to two rate cuts.

Key Point 2: How will GDP growth forecasts and PCE inflation forecasts be adjusted?

Despite the slight rebound in month-on-month core CPI growth in November and stubborn inflation in the services sector, coupled with the unexpected drop in the non-farm unemployment rate to 3.7% announced last week, the market generally expects that next year's economic growth and inflation will be revised downward on a year-on-year basis, while the unemployment rate may be adjusted upward.

New York Fed President Williams previously predicted that the Fed's most important inflation indicator, PCE, will fall to around 2.25% in 2024 and approach 2% in 2025.Highlight 1: Morgan Stanley predicts economic slowdown to 1.25% next year

Morgan Stanley's team pointed out in their report that the PCE in September next year will drop to 1.8%, below the Fed's target of 2%, while the economy will not enter a recession. UBS economist Alan Detmeister stated that the current resolution of supply issues is gradually causing prices to fall, and he expects the US inflation rate to drop to 1.7% in the fourth quarter of 2024.

Highlight 2: How much internal divergence is there within the Fed?

Unlike previous meetings, several Fed officials sent dovish signals before this interest rate meeting.

Christopher Waller, a Fed board member and influential hawkish voice within the Fed, surprised the market with his dovish remarks:

I am increasingly confident that current policies can effectively slow down economic growth and bring the inflation rate back to 2%.

Most officials support maintaining the status quo. Powell reiterated recently that it is still too early to consider tightening monetary policy, and that the risks of insufficient tightening and excessive tightening are in a more balanced state.

Meanwhile, Fed board member Bowman and Cleveland Fed President Mester's statements are more hawkish, and they expect another rate hike this year. The market generally believes that the internal divergence within the Fed will not affect the final voting result.

Highlight 3: What changes in the Fed's monetary policy statement are worth noting?

Analysts generally believe that there may be some adjustments in the wording of the Fed's assessment of employment, inflation, housing, and overall economic growth. Bank of America believes that the Fed may abandon the phrase "further tightening of policy" and instead emphasize its commitment to bringing the inflation rate down to 2%.

Goldman Sachs also believes that the policy statement may exclude descriptions of tightening financial conditions and make some minor adjustments to other language previously used to express a bias towards rate hikes.

According to Goldman Sachs' financial conditions index, US financial conditions have returned to the level seen in June last year.

Analysts believe that Powell's statement at this press conference may still be neutral, continuing to emphasize "data dependence" in response to the changing economic and market outlook. This also means that the market's overly optimistic expectations for rate cuts are difficult to be fully corrected.

Will the European Central Bank be the first to start an interest rate cut cycle?

At 21:15 on December 14th Beijing time, the European Central Bank will announce its latest interest rate decision. The market generally believes that the ECB's path to rate hikes has reached a turning point and that it will cut rates earlier and faster than the Fed. At the same time, the ECB's next steps regarding the Pandemic Emergency Purchase Programme (PEPP) will be the focus of market attention.Key Point 1: How should the European Central Bank manage expectations?

Recently, against the backdrop of a significant cooling in European inflation data, the ECB's Governing Council has been gradually sending signals to the market that the rate hike has stopped. The shift from hawkish to dovish officials, coupled with overall weak economic data, has led to a significant increase in market expectations of a rate cut.

Earlier in December, Isabel Schnabel, known as the "hawk king" of the ECB's Governing Council, stated that the decline in inflation is "significant and encouraging," and the ECB may not further raise interest rates. Overnight euro index swaps indicate that the market expects the ECB to start cutting rates in April next year, with a total of 5 rate cuts accumulated as of October (data updated only until October). This is earlier than the market's bet on the Fed starting to cut rates in May next year.

It is believed that ECB President Lagarde may try to ease market expectations of a 25 basis point rate cut in April next year.

Recent data shows that the eurozone's inflation rate in November rose by 2.4% year-on-year, reaching its lowest level in over two years. Economic data also shows further signs of weakness, with the eurozone's November Markit Composite PMI final reading at 47.6, better than the market's expected 47.1, but still below the 50 threshold.

Despite the economic slowdown, in order to avoid excessive market easing, Lagarde is following Powell's lead in "raising rates with words" to manage expectations in the market, vowing to bring inflation back to target levels:

"The battle is not over, and we certainly won't declare victory."

Joachim Nagel, President of the German Central Bank, also warned the market recently that it would be a "mistake" to start easing monetary policy too early. Similarly, Governing Council member Gabriel Makhlouf also stated that he could not rule out the possibility of "taking another step up" and that it is "too early" to talk about rate cuts now.

Key Point 2: Will the ECB exit the PEPP reinvestment program?

Analysts generally believe that the market's increasing expectations of an ECB rate cut are affecting the Governing Council's accelerated exit from the Pandemic Emergency Purchase Program (PEPP). At last month's interest rate meeting, the ECB stated that the reinvestment plan for PEPP would continue until at least the end of 2024. Currently, the portfolio size of PEPP is 1.7 trillion euros (about 1.9 trillion US dollars).

Goldman Sachs, Barclays, and BNP Paribas believe that the ECB will accelerate its exit from PEPP, similar to the launch of quantitative tightening by canceling the Asset Purchase Program (APP). This could mean that the ECB will announce at its last meeting of the year that it will start reducing the reinvestment plan for PEPP from the end of the first quarter of next year, and provide more details at the next policy meeting in January.

Lagarde stated last month that the PEPP plan will be reassessed soon, and several members of the ECB's Governing Council have already expressed support for the idea of "starting to reduce PEPP earlier." Last week, Robert Holzmann, one of the Governing Council members and President of the Austrian Central Bank, stated that he supports discussing this matter at the December interest rate meeting and gradually reducing reinvestment starting from March next year.On behalf of Dolphin Research, I would like to express our gratitude for your continued support and interest in our work. We are thrilled to announce the release of our latest Analysis Report, which provides a comprehensive overview of the current market trends and developments in the industry.

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