Fed Raises Rates, USD Surges in Response

The US Federal Reserve increased interest rates by a quarter point today, also indicating that it now expects to increase rates three more times in 2017.

“In view of realised and expected labour market conditions and inflation, the committee decided to raise the target range for the federal funds rate to half to three-quarters per cent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labour market conditions and a return to 2% inflation,” says the Federal Open Market Committee in a statement issued today.

Meanwhile, in a press conference after the news was announced, Fed chair Janet Yellen said that the decision was made in response to “the considerable progress the economy has made toward our dual objectives of maximum employment and price stability”.

She added: “Over the past year, two-and-a-quarter million net new jobs have been created, unemployment has fallen further and inflation has moved closer to our longer run goal of 2%. We expect the economy will continue to perform well, with the job market strengthening further and inflation rising to 2% over the next couple of years.”

Economic projections released by the Fed show that it revised its growth forecast, predicting that the US economy will grow by 1.9% in 2016 and 2.1% in 2017. In September, the forecast was 0.1% lower for each year.

The projections also show that the central bank expects to increase rates three times in 2017, to a rate of 1.4% by year’s end. In contrast, the September projections signalled only two expected hikes next year, forecasting that 2017 would end with the rate at 1.1%.

“As widely expected, the FOMC delivered the second rate hike in this cycle, precisely 12 months after its first move. However, in a major surprise it increased its expectations for the likely rate path in 2017 to three hikes rather than the two forecast following its September update. It seems that in light of the forthcoming Trump fiscal stimulus plan and signs of both rising price pressures and inflation expectations (helped by the recent OPEC decision to cut oil output), the Fed felt that it needs to adopt a more aggressive rate hiking path,” says Lee Ferridge, head of multi-asset strategy for North America at State Street Global Markets.

He adds: “Whether these three hikes are actually forthcoming, however, now depends on the economic impact of the Trump proposals. While the market (and it now appears the Fed) certainly seem to believe that the Trump plan will deliver a meaningful boost to growth next year, the jury is still out. For now, the Trump fiscal plan consists of tax cuts concentrated on higher earners and a net reduction in spending, albeit with extensive tax breaks for private investors to undertake infrastructure investment. It is certainly a matter for great debate whether this fiscal mix will be sufficient to overcome the headwinds created by a stronger dollar and higher domestic US rates.”

In contrast to this, Greg Anderson, global head of FX strategy at BMO Capital Markets, says that he was not surprised by the change in prediction for rate hikes next year.

“I’m not surprised that they moved it to three. If you look at the OIS curve and where those hikes are, the hikes are more priced in to June, September and December, but in my mind I think this is more likely to be March, June and December. I feel like there’s a little more room to run in this story, but maybe not this year, probably in January 2017 when we take a look at the inflation outlook. 

“This is the part that surprised me: the Fed didn’t raise its inflation outlook for 2017 when they should have, given OPEC putting a nice floor under oil. But that’s a story that can come out early next year and so I do look for a little more dollar upside in January and February period,” he says.

Similarly, Bob Savage, CEO at CCTrack, says that today’s announcement was “about par for the course”.

“There’s clearly room for higher rates in 2017, but that’s going to be dependent upon the data and how the Trump presidency leads to fiscal stimulus and how that stimulus is paid for,” he adds. “I’m interested to see that equities pulled back, the fact that interest rates are beginning to have an effect on equities is an interesting correlation, because in FX, normally when you get an equity market turndown you get USD/JPY going lower, not higher.”

USD/JPY went from 115.25 at 1pm EST, before the Fed announcement, up to 117.20 at 4pm EST.

According to Savage, this “puts 120 at the year-end back in play, which means a full circle for the Bank of Japan and could have profound effects for a lot of currencies in Asia, particularly the yuan”. 

As demand for USD surged following the rate hike decision, it strengthened keenly against the euro, a currency that was already enduring a bad week after the Eurozone’s quantitative easing programme was extended last week.

At 1pm EST, before the Fed announcement, EUR/USD was trading at 1.0650 and by 4pm it was down to 1.0524.

While Anderson says that this USD strength is sustainable, he doesn’t expect to see another surge in the currency before the end of the year.

“What I expect to see happen is people quietly, cautiously, carefully back out of long dollar positions and the dollar to hold while they do that. That re-primes the pump so when those people come back in early January and buy back their position, we move a couple of percent higher,” he says.

Savage agrees that the USD strength is sustainable, but does sound a note of caution for those anticipating a surge in the currency early next year.

“What is interesting is the fourth quarter GDP has been cut pretty substantially by forecasters in the last few weeks and retail sales and industrial production today were weaker,” says Savage. 

Given that Q1 GDP has been poor for the past five years, he questions whether this could impact how the Fed behaves. “The idea that we could have two quarters of 2% GDP and a very aggressive Fed might be things that don’t mix. So, viewed over the medium-term, today’s reaction could be viewed as at risk of being over done, and that makes me suspect that the USD rally in the middle of January after the final fourth quarter GDP data is released could be at risk,” he adds.

galen@profit-loss.com

@Galen_Stops

@Profit_and_Loss

Galen Stops

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