Federal Reserve to hold rates, keep December hike alive

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The Federal Reserve will be announcing its latest interest rate decision following its two-day monetary policy meeting on Thursday. While policymakers in the US are almost certain to leave rates unchanged, investors will be eagerly hoping to gain a much clearer picture as to the possible path of future rate hikes.

The US Dollar fell sharply following the Federal Reserve’s most recent meeting in July in which rate-setters in the US kept policy unchanged, while explicitly acknowledging weaknesses in domestic inflation. The FOMC changed its rhetoric on price growth, claiming that the headline rate was running “below” the 2% target compared to the “somewhat below” that was included in the previous statement in June.

Currency traders latched onto the Fed’s somewhat dovish turn, pushing back expectations for the pace of additional monetary tightening and discounting the possibility of a third rate increase in the calendar year in December. An unwinding of expectations for additional rate increases in 2017, combined with President Trump’s inability to force through any meaningful policy changes in the US, has caused a sharp sell-off in the greenback. The US Dollar slumped to a twenty month low in early September and has now lost over 10% of its value since the December 2016 hike (Figure 1).

Figure 1: US Dollar Index (September ’16 - September ’17)

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Source: Thomson Reuters Datastream Date: 15/09/2017

Amid the relatively less optimistic assessment of the US economy, the FOMC kept its interest rate projections broadly unchanged in its most recent ‘dot plot’, although this did come back in July. The market at present appears to be clinging onto the possibility of another rate increase this year, with Fed futures currently attributing around a 47% chance of a move before the year is out (Figure 2).

Figure 2: FOMC Rate Hike Probability December 2017 (May ’17 - September ’17)

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Source: Bloomberg Date: 15/09/2017

Weaker Inflation Dynamics

 

Economic news out of the US since the release of the Fed’s last ‘dot plot’ has been fairly mixed. Inflation has slowed since the beginning of the year when it jumped to a five year high just shy of 3%, printing back below the central bank’s target level in each of the past four months (Figure 3). The headline rate did edge upwards to 1.9% in August which could, if it were to persist, provide the Fed room to alter policy in December.

Figure 3: US Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 15/09/2017

Growth has also surprised to the upside and was revised to a three year high 3% in the second quarter. The Fed will, however, be wary of the economic disruption caused by both Hurricane Harvey and Irma. This poses a potentially significant downside risk to the outlook, the estimated cost of which has ranged between anything from $70-$300 billion (approximately 0.5-1.5% of US GDP). We’ve already seen a negative impact of the adverse weather on the latest jobless claims data, which spiked to a two year high earlier this month.

What to expect from the Fed on Wednesday

 

We think that the Fed is certain to keep interest rates unchanged at its meeting on Wednesday with the key to the US Dollar likely to be the latest ‘dot plot’, which shows where each member of the committee expects rates to be at the end of each year. Following the recent slowdown in inflation the median projection of future hikes may be modestly downgraded, which could pressure the greenback lower. However, any rhetoric that expresses optimism over the inflation outlook and overlooks the downside risks to the growth outlook could temper losses. We expect Chair Janet Yellen to keep the possibility of a December hike firmly on the table.

Even a relatively sharp downward revision to hike projections on Wednesday would ensure there is still a clear disconnect between market pricing and the Fed’s expected path of future hikes (Figure 4). This, in our view, is unsustainable, and we still expect a medium term bounce back in the Dollar against most major currencies once market expectations come in line with that of the Fed.

Aside from the vote on rates, the Fed is widely expected to announce it is ready to begin shrinking its vast balance sheet, the bulk of which was accumulated during the central bank’s quantitative easing programme. This would involve winding down the existing $4.5 trillion worth of bonds over the coming few years.

Figure 4: FOMC ‘Dot Plot’ vs. OIS Curve (2017 - 2019)

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Source: Bloomberg Date: 15/09/2017

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