Pre-FOMC Meeting - March 2017

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Federal Reserve prepares market for March interest rate hike

 

Expectations for another interest rate hike by the Federal Reserve at the central bank’s 15 March meeting have grown sharply in the past few days following hawkish comments from a number of senior FOMC policymakers.

Speaking in Chicago on 3 March, Chair of the Federal Reserve Janet Yellen claimed that “waiting too long [to hike rates] could potentially require us to raise rates rapidly sometime down the road”. We think Yellen all but confirmed that the Fed would hike interest rates for only the third time in a decade this month, saying that a move in March would “likely be appropriate”.

This follows a string of hawkish commentary from a number of other senior rate setters in the US in the past few weeks. San Francisco Fed President John Williams said that a March hike was up for "serious consideration", Patrick Harker repeated his expectation for three hikes in 2017 while William Dudley claimed the case for raising rates had become a lot more compelling.

This consistently hawkish rhetoric is in line with the generally solid economic fundamentals in the US since the last hike in December, with the Fed now close to achieving its dual mandate of full employment and stable price growth. The all-important US labour report in March showed a modest improvement in unemployment, with the jobless rate remaining around its lowest level in nine years at 4.7%. Job creation also came in at a very healthy 235,000 in February (Figure 1) with the twelve month moving average of payrolls now back around the 200,000 level. This is considerably above the 145,000 that is believed necessary to keep up with growth in the labour force. Average earnings are growing at a healthy pace of 2.8% year-on-year, and the trend is clearly upwards. The four week average of initial jobless claims has also fallen to a fresh 44 year low in another sign of tightening in labour market conditions.

Figure 1: US Nonfarm Payrolls (2010 - 2017)

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Source: Thomson Reuters Datastream Date: 13/03/2017

Moreover, inflation in the US has continued to increase at a steady pace back towards the central bank’s target. The headline rate of consumer price growth increased to 2.5% in January and core inflation ticked upwards to 2.3%. Personal consumption expenditure prices, closely watched by the Federal Reserve when deciding on monetary policy, has also increased sharply over the past few months to 1.9% in January, just below the Fed’s 2% target (Figure 2).

Figure 2: US Inflation Rate (2010 - 2017)

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Source: Thomson Reuters Datastream Date: 13/03/2017

We have been calling for a March hike and no fewer than three hikes during 2017 since right after the US elections back in November. This possibility was priced by rate markets at well under 25% at the time, and very few strategists and economists had more than two hikes in their forecasts. As we go into the March meeting, financial markets have now overwhelmingly come around to the idea that the Fed will raise rates far more aggressively this year than originally anticipated. Fed fund futures are currently pricing in excess of a 95% possibility of a hike this month (Figure 3), sharply higher than the 30% priced in a fortnight ago.

Figure 3: Implied Probability of March Fed Interest Rate Hike (January ’17 - March ’17)

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Source: Bloomberg Date: 09/03/2017

Currency markets have reacted in unsurprisingly fashion to the prospect of higher rates in the US, with the US Dollar rallying in line with the growing possibility of a March hike. The US Dollar index surged to a seven week high last week, appreciating by almost 3% from its early February lows (Figure 4). The bond market has also reacted accordingly, with two-year US Treasury bills surging to their highest level since 2009.

Figure 4: US Dollar Index (March ’16 - March ’17)

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Source: Thomson Reuters Datastream Date: 13/03/2017

Communications from the Fed have taken a distinctly hawkish turn in the past few weeks, overshadowing recent policy uncertainty and protectionist rhetoric out of the Trump administration. We think it’s clear the Fed is preparing the market for an immediate rate increase and now see it as a near certainty that the central bank will hike rates in March. We also expect the FOMC to move further up its projection of future rates from the December ‘dot plot’ (Figure 5). We think that the median forecast will be for 4 hikes each year in 2017 and 2018, bringing the main Fed funds rate to 1.5-1.75% at the end of 2017 and 2.5-2.75% by year end 2018.

Figure 5: FOMC March 2017 ‘Dot Plot’ Forecast

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Source: Bloomberg Date: 09/03/2017

While a March hike is entirely priced in by markets, we do not think investors are quite prepared for this upgrade in ‘dot plot’ rate forecasts and see potential for a sharp US Dollar rally as a result immediately after the release.

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