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Markets underestimate Fed’s ability to hike rates

 

The essential

Financial markets remain cautious about the ability of the Fed to hike the fed funds over the coming quarters: indeed, a majority of investors expect, at best, a single hike until the end of 2018. We think that this view is too pessimistic.

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19 September 2017

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19 Septembre 2017

 

Why so much skepticism?

  • The unexpected weakening of inflation (both core and headline inflations) in H1 2017.

The Core CPI has stabilized since May at 1.7% after reaching 2.3% last January. However, some slowdown can be explained by one-off factors that will disappear from inflation calculation in a few months. The US dollar depreciation since the beginning of the year should boost imported inflation. The rebound of the CPI and core CPI indices in August is sending a positive signal. About underlying inflation, one of the main elements to follow in 2018 will be the evolution of shelters, the main contributor to underlying inflation, slightly slowing over the last months.

  • The disappointment of markets vis-à-vis the expectations born with the election of Donald Trump.

The GDP growth forecasts from the consensus for 2017 and 2018 have been slightly downgraded while global GDP growth forecasts have been revised upwards in the meantime.

 

1/Markets' expectations for the fed funds

2017-09-19-graph1

 

Why the Fed should continue its fed funds tightening cycle

 

  • The Fed’s dual mandate is almost fulfilled:

the unemployment rate is already below the longer-run level estimated by FOMC members and inflation is not that far below the Fed’s 2% inflation target. Besides, the other measures of slack in the labour market are improving as well.

  • The activity indicators improved recently.

The Q2 growth figure has been rather good, at 3% in annualized terms. Economic surprise indices, which were very negative in June, improved strongly since then. In August, the manufacturing ISM hit a six-year high.

  • The monetary policy remains accommodative.

With a natural rate (equilibrium real short-term interest rate) estimated around 0%, the current fed funds target range (1.00%-1.25%) can be considered as accommodative.

  • The issue of the risk of financial stability is increasingly fuelling the debates of the FED.

- Minutes of the last FOMC pointed out that an environment of low interest rates and a relatively flat yield curve, if it persisted, had the potential to boost incentives to take on leverage and risk.

Valuation pressures appeared to have risen for some types of assets FOMC members warned that the recent increase in equity prices might in part reflect investors’ anticipation of a boost to earnings from cut in corporate taxes or more expansionary fiscal policy, which might not materialize. Some participants also expressed concern about the low level of implied volatility in equity markets. The Fed admitted also commercial real estate is a big concern.

 

 

2/ Fed funds target vs financial conditions indices

2017-09-19-graph2

3/Effective fed funds vs market expectations

2017-09-19-graph3

 

  • Financial conditions eased since the beginning of the fed funds tightening cycle (December 2015).

During previous fed funds tightening cycles, either financial conditions remained stable or they tightened. Several indicators like the Saint Louis financial stress index at close to an all-time low. William Dudley, the New York Fed’s president said on September 7: “if financial conditions ease even as we are removing monetary policy accommodation, this may have implications for further policy adjustments. All else equal, an easing of financial conditions may warrant a somewhat steeper policy rate path.”

 

The Fed should announce during the September FOMC (20 September) the beginning of its operation of balance sheet reduction: in the first place, it will not reinvest $6bn of US Treasuries and $4bn of MBS every month of its maturing holdings (these amounts will be raised each quarter thereafter). This mechanism will be very gradual and it should not have a significant impact on long-term interest rates in the short-run. One of the elements to follow at the September FOMC will be the evolution of the “dots”, mostly for 2017 (indicating 3 hikes for 2017 would raise strongly the expectations for a December hike).

 

In conclusion, we think that markets are too pessimistic about the ability of the Fed to hike its fed funds until the end of 2018 and that real yields are too low as a consequence. It is important to remind that after having hiked far less than what was priced in by the markets, the Fed has hiked much more over the last 12 months than what was priced in one year ago.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Monetary policy remains accomodative

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One of the elements to follow at the September FOMC will be the evolution of the "dots"

 

 

 

 

 

 

 

 

 

 

 

 

AINOUZ Valentine , CFA, Credit Strategy
DRUT Bastien , Fixed Income and FX Strategy
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Markets underestimate Fed’s ability to hike rates
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