The most anticipated event this week was clearly the FOMC meeting announcement on Wednesday night. A key question was to what extent a so-called data-dependent Fed would factor in a string of weak data, notably on the inflation side and change the stance of its monetary policy. Markets had remained remarkably convinced that a hike was in the making but we were less sure and stood by our call that the data-dependent Fed would keep rates unchanged and instead announce details about their plan for reducing the balance sheet, also called quantitative tightening.
In the end, the Fed both hiked its policy rate by 25 basis points AND laid out its plans for the reduction of its balance sheet. At the same time, the Fed continued to signal another hike this year and three hikes next year. How did Fed governor Yellen sell this rather hawkish twist to monetary policy and what will the market implications be in the near and longer term?
The FED meeting on Wednesday clearly signalled a shift in the Fed’s focus. It downplayed the drop in core inflation as temporary (although Yellen did say that they are monitoring inflation developments ‘closely’) while attaching greater importance to the fall in unemployment rates, which they expect will reignite wage growth and help push up inflation to the central bank’s two percent target. With the US economy expected to grow close to 2% over the next two years, we should see further falls in the unemployment rate.
But we have doubts how fast this will translate into a higher wage growth and thereby inflation. At the press conference, Yellen did acknowledge that the US Phillips curve is rather flat (meaning that the low unemployment rate is not yet translating into higher nominal wage growth) and that the estimate of the unemployment rate below which wages start to rise faster is uncertain. Following the meeting, we are still expecting a hike in December but have become less certain while now only expecting 1-2 hikes next year (down from 3).
Fixed income: long-term yields kept in check
While the more hawkish Fed has certainly put upward pressure on the shorter end of the yield curve, the case for higher longer term yields is more uncertain at least near term. So far the longer-term US yields have declined following the Wednesday meeting. While the balance sheet reduction will soon be started by the Fed, it will still be re-investing sizeable amounts. Furthermore, the relatively weak inflation pressures and expectations also limit the pressure on long-term yields. Furthermore, both Bank of Japan (this morning) and the ECB (last week) signalled no rush to exit their quantitative easing programmes, which will also help keep a lid on global long-term rates. Hence we continue to see the longer-term yields being held in check for most part of 2017.
Equities: sell on rallies near-term
The Fed decisions on Wednesday are not fundamentally changing our view. We still see equities going through a mild downward adjustment following sizeable gains in the spring and stretched valuations. However, if we get a third hike this year as signalled in the dots (our take would be in December), then this could change and we would find ourselves in a situation similar to 2004-05, where US-T sold off, while equities fared fairly well.
FX – further downside to EUR/USD near-term, higher later in 2017
The hawkish twist to the Fed’s decision on Wednesday is clearly aiding the USD. This has lent support to our tactically bearish EUR/USD trading recommendation. We continue to see further downside for the cross near-term with the ECB being side-lined in coming months by a sustained deterioration in the inflation outlook and a Fed determined to move on with policy normalisation. Furthermore, the mixture of a BOJ continuing its extraordinary easing programme and the Fed moving towards the exit should also support the USD/JPY, where we see the cross moving to 112 in 1-3M and 116 in 6-12M.
Rising risk of a slowdown in China
It was noteworthy that the Fed removed the monitoring of ‘global economic and financial developments’ from its statement on Wednesday, indicating that it is less concerned about the negative impact of global developments on the US economy. This may in our view be a bit premature as we see rising risks of an economic slowdown in China after the withdrawal of stimulus measures and the crackdown on the shadow banking sector. This week we saw a further slowdown in credit supply, falling to the lowest level since October last year, mostly on account of a sharp contraction in shadow banking finance. Adding in a more hawkish Fed, the pressure on Chinese economies markets may grow in the coming months, which risks having repercussions for the global economy.
