06 Mar 2017
Fed very likely to hike in March and continue gradual rate rises thereafter
Fed announcement next week: The Federal Open Market Committee meets for its second meeting of the year next week with the policy announcement due at 18:00 (UK time) on 15 March. Updated forecasts will published at this time and Fed Chair Janet Yellen will give her press conference at around 18:30.
Expect a March hike: Last week we witnessed a concerted effort by FOMC participants to ensure that the March meeting was fully live, but also with Fed speakers providing a firm pointer to the prospect of another move in rates at that meeting. We have changed our view and now expect to see a 25bp increase in the Federal funds target rate range to 0.75-1.00% next week. Rounding off a week littered with Fed commentary, Fed Chair Yellen said ‘the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate’. This is a clear pointer to a March move, short of a disastrous payroll print on 10 March, a major fall out in discussions over the US debt ceiling (the suspension expires at midnight after the Fed decision) or a sizeable shake out in market sentiment. Note that the Fed funds futures curve points to a more than 85% chance of a 15 March hike, whilst the CME FedWatch measure puts the chance at almost 80%, from around 30% a week earlier.
Fed encouraged by sentiment, not hard data: The turnaround in Fed messaging has been quite marked from Janet Yellen’s relatively relaxed monetary policy testimony to Congressional committees on 14/15 February and a set of FOMC minutes that said the Fed would raise rates ‘fairly soon’. Previously the Fed has signalled an upcoming rate move more strongly in earlier pre-meeting communications and often in the previous meeting’s policy statement. We suspect the shift has been driven in part by continued gains in US stock indices which have breached new highs over recent weeks whilst sentiment/survey indicators have broadly pressed higher too. The underlying economic data has been less robust, but it may be that the Fed has seen an opportunity to get another rate move in at a time when sentiment appears resilient, and plans to make the most of that. Of course, one lesson here is to watch out for the prospect that the Fed will now issue any policy guidance closer to its pre-meeting ‘blackout’ period than in recent history, limiting its risk of having to back track.
Three hikes in 2017? In terms of the upcoming meeting’s policy statement, forecasts and press conference, assuming a March hike is observed, one thing to look out for will be the guidance issued on the path for rates here forward. Note that, factoring in a March hike, we are now of the view that the Fed will lift rates three times this year. We see the Fed funds target rate range ending the year at 1.25-1.50% (prev. 1.00-1.25%). It is possible that we see one (possibly Neel Kashkari of the Minneapolis Fed) dissention to any March 15 hike, but in general we view the FOMC comments of the past week as indicative of a Committee that is broadly happy with the intention to progress with gradual normalisation thereafter. We would expect the Fed’s updated ‘dot plot’ to continue to signal three hikes in 2017. Note that laying out a path for rates in 2018 is complicated by a debate to be had on whether the Fed should halt re-investment of some of its $4.2bn QE holdings.
Underlying momentum to help normalisation along? Note that in her 3 March speech, Fed Chair Yellen gave a further pointer to the three hikes (in 2017) view, saying ‘a cumulative ¾ percentage point increase’ would ‘likely be appropriate over the course of this year’. She also indicated that the pace of normalisation would exceed that seen in 2015 and 2016 (which has averaged one 25bp hike a year). Note that over the past two years global events have often been the block to Fed normalisation plans, not least concerns over developments in Chinese stock markets in Q1 2016. There are plenty of risks which could rear their heads in 2017 under a Trump administration, though we judge that a more solid US and global economic backdrop alongside rising inflation, should help to keep Fed normalisation more on track. Our new Fed interest rate forecast profile is in table 1 (please click here).
Currency view unaltered: One final point to note is that we have not shifted our foreign exchange forecasts having included one additional Fed hike in the 2017 profile.
- One key driver for our forecast, which sees the USD cede ground against the Euro and the pound (€:$ $1.18 end-2017 and £:$ $1.35 end-2017) is the apparent undervaluation of the both the Euro and sterling against the dollar. Our own PPP fair value models suggest that GBP is roughly 25% undervalued and the EUR 15%; we see a gradual appreciation back towards fair value levels. For the Euro, talk of ECB tapering towards year end should support the single currency. For the pound, a resilient UK economy and more clarity on Brexit should be supportive factors. We believe that these effects, particularly on fair value momentum, dominate the effect of Fed policy moves.
- Note that specifically on Fed normalisation and the USD, 2004 provides an interesting case study. When the Fed started lifting rates in June 2004 the USD subsequently fell 5.5% over the following two years, despite the Fed tightening more aggressively than markets had expected – the FOMC enacted 25bps increases at 17 consecutive meetings, taking rates from 1.00% to 5.25%. And over the course of last week, when an additional 15bps of tightening was priced into the Fed funds futures curve by December 2018, the USD move was relatively contained and also likely lifted by a conciliatory tone struck by President Trump in his Congressional statement.