Fed overview: when 2 became 3, and a side of Trump
City Index December 15, 2016 2:08 AM
<p>So, here we have it, the Fed has delivered the expected 25 basis point rate hike this evening, and its latest ‘Dot Plot’. FOMC members […]</p>
So, here we have it, the Fed has delivered the expected 25 basis point rate hike this evening, and its latest ‘Dot Plot’. FOMC members now expect three interest rate increases next year, that is up from the two rate hikes expected back in September. Yellen and co. won’t be removing Trump’s punchbowl quite yet, although they will be keeping a very close eye on it in 2017 and beyond.
Trump gets airtime
Although he wasn’t actually present in the room, Trump was the centre of attention at this press conference. Yellen said that the FOMC had discussed Trump’s win and his potential fiscal policies. She also said that members of the FOMC staff had met with Trump’s transition team, although she had not. The markets may be getting giddy on Trump, but the mild upgrade to the Fed’s GDP forecast, and the slight shift lower in its expectations for the unemployment rate, along with expectations that rates will only rise to 3% over the long term, suggests that the jury may still be out on the effectiveness of Trumpenomics at the Fed.
Markets waste no time looking for rates in 2H 2017
The Fed Funds Futures market has rushed to price in these three rate hikes in the second half of the year. It is currently pricing in a 75% chance of a rate hike in June, 77% chance in July, 86% in Sept 88% in November and 94% in December. The reason for this is sound; it will take time for any Trump stimulus to feed through to stronger growth and inflation.
This makes March’s meeting, when we get the next ‘Dot Plot’ and Yellen press conference, the most important central bank meeting in Q1 2017 for financial markets. By then Trump will have been in power for two months, and we should know some details of his fiscal plan. If Trump’s desire to have a fiscal stimulus plan on steroids is approved by Congress, then it is hard to see how we won’t get a larger upgrade to growth, employment and inflation rates at the Fed, which could lead to more rate hikes next year, potentially earlier than is currently expected.
The King dollar resumes its upward march
The market reaction is as expected: the dollar has surged, it is testing the 24th Nov high at 102.05, and we expect it to break a new multi-year high at some stage during the back end of the US session. USDJPY, which is sensitive to shifts in Fed policy, rose to the highest level since February. US Treasury yields are also rising sharply, 2-year yields are at their highest level since 2008, while the German 10-year – US 10-year yield spread is close to a record low, it is currently at -2.24%, the lowest ever level was in the late 1980’s at approx. -2.3%. This has triggered a sharp decline in EURUSD, which broke below 1.05 earlier, which opens the way to parity. GBPUSD has also fallen 150 pips since the decision. Oil is also lower, as the strong dollar weighs on prices.
So, why the big reaction in FX and bond markets?
Perhaps it wasn’t Yellen’s muted message that rate expectations have only adjusted slowly, but that the market expects Yellen to have to re-adjust her forecasts in March once Trumpenomics truly gets going. Right now, the Fed’s central tendency for core PCE inflation is only 2%, in line with the Fed’s own inflation forecast.
Is the Santa rally over?
In contrast to the exuberance in FX and bond markets, the stock market reaction has been retrained. Stocks are weaker on the back of this meeting; however, they haven’t fallen off a cliff. If we see buyers pick up the dip, then the Santa rally might actually make it to Christmas.
Overall, this meeting sets the stage for a more interesting update from the Fed in March. So far, Donald Trump has managed to refrain from tweeting about the Fed decision, thus reinforcing a commitment to maintain the Fed’s independence. But watch his twitter feed in case he does opine on what he thinks of Yellen later on.
GAIN Capital UK Limited (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.
No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.