- We expect the Fed to raise the target range by 25bp to 1.50-1.75%.
- We expect the Fed to maintain the hiking signal at 3 hikes this year but lift the median dot for next year from 2.25 to (close to) 3 hikes. We also expect the Fed to raise rates three times both this year and next year.
- The hike is unlikely to steer a new direction for USD. We think Trump policies are more important for USD at present. Near term, EUR/USD is set to stay in the 1.21- 1.26 range.
- 5y point on the US curve could see upward pressure. We expect the US curve to continue to flatten both 2y10 and 5y10y after the FOMC meeting.
Fed to maintain three hikes signal for 2018
In line with market pricing and consensus, we expect the Fed to raise its target range by 25bp to 1.50-1.75% at next week’s meeting. We expect the Fed to maintain the three hikes signal for this year but showing more confidence in the signal, as more of the dovish members now seem to support this. If we are right, this would likely be interpreted dovishly, as markets are speculating whether the Fed is about to hike four times this year. Markets have already priced in three hikes this year, which is quite a lot at this point. We think the recent average hourly earnings and CPI data support this. However, we note that some of the most outspoken doves do not vote this year (Bullard, Evans, Kashkari) meaning that the median dot among the voting FOMC members is likely higher than the median dot among all members. In this sense, we agree with markets that the balance of risk is skewed towards a fourth hike although three remains our base case. New Fed Chair Jerome Powell also sounded slightly more hawkish at his hearing before Congress (at least on day 1, as he downplayed it on day 2), as he said his ‘personal outlook has strengthened’, see Flash Comment US: Powell says ‘personal outlook has strengthened;, 27 February. We do not expect big changes to the statement. The Fed will likely repeat that risks are ‘roughly balanced’, that it still monitors inflation ‘closely’ and that it expects ‘further gradual increases’.
We think the Fed will signal it is time actually to hit the brakes by raising the Fed funds rate above the longer-run dot of 2.75% (the Fed’s view on the nominal level of the natural rate of interest when the economy has normalised) in coming years, as we expect the Fed to raise the dot signal for 2019 from slightly more than 2 hikes to (close to) 3 hikes. This implies a Fed funds rate at 3.0% by the end of 2019. Markets have only priced in slightly more than four hikes from now until year-end 2019, against our expectation of six hikes.
Although we expect the Fed to signal that more hikes are needed than projected in December on the back of a more expansionary fiscal policy, we do not think the Fed will offset it one-to-one, implying the total policy mix is becoming more expansionary. That is also why we argue that there are upside risks to our US inflation forecast, especially next year.
Powell to stick to current policy strategy near term
It is Jerome Powell’s first meeting as a Fed chair so his interaction with the press during the Q&A is also going to be interesting to follow. Based on his hearing before US Congress, it seems that he has a more direct approach than Yellen. One important thing, which Powell confirmed during his Q&A, is that he relies more on policy rule guidance going into Fed meetings (looking at a range of rules, not just one). In the Fed’s Monetary Policy Report – February 2018 (released Friday 23 February) the Fed describes a few rules – see our tweet, 27 February.
Powell is sticking to the Fed’s existing tightening strategy by continuing the gradual hiking cycle (and shrinking the balance sheet). What will be more interesting will be how Powell reacts should the economy or financial markets be hit by a shock in either direction. Powell is less qualified than Yellen (in terms of academic credentials) and the Fed will be less experienced (many new members). We wrote more about this topic here FX Edge – inexperienced Fed to be a drag on USD, 30 November).
We expect the US yield curve to flatten further
The confirmation from the Fed that they still ‘only’ plan to hike three times this year should make the market scale back slightly the 75bp priced for 2018, as only two hikes in 2018 again is a viable option. However, the lift in the 2019 ‘dots’ works in the other direction. It will be a strong signal from the FOMC. It will be a surprise to the market that a majority of the members are actually now ready to lift the Fed Funds above the 2.75% longer-run dot. The latter points to a repricing of the single hike priced in 2019 and the 5y point on the US curve in particular could see upward pressure. All in all, we expect the US curve to continue to flatten both 2y10 and 5y10y after the FOMC meeting.
Fed March hike unlikely to steer a new direction for USD
On average, with the Fed unlikely to signal four hikes this year, but possibly upping rate expectations for 2019, a March hike is unlikely to steer a new direction for USD. Notably we stress that a hike in itself is unlikely to provide much dollar support given that is seen as a ‘done deal’ by the market. More broadly, we stress that actual movements in interest rates are indeed of little use in predicting USD moves at present as the Fed has entered a phase in the policy cycle – notably versus e.g. the ECB – during which the currency historically has not seen a clear direction from central-bank policy (see chart). Rather than the Fed, we think Trump policies are more important for USD at present, i.e. how the president’s ‘America first’ agenda plays out will be key for the medium-term direction for dollar crosses, see FX Strategy: Trump in MEVA space: US isolation puts USD at risk, 14 March 2017. Near term, EUR/USD is set to stay in the 1.21-1.26 range as the ECB is reluctant to allow a more aggressive pricing of its normalisation process.
