Last night’s Fed rate hike, with more balanced that expected accompanying material, seems to have given the green light to further limited (short-end US) yield rises and consequent USD dollar strength over the next few months. The latter will likely supported by gradual increased pricing of policy divergences – the Fed seems confident in anticipating four rate hikes in 2016 versus only two priced by markets while the risks seem skewed to further ECB easing (see here) and most other central banks won’t be hiking any time soon – commodity price downsides and potentially-growing flow-based support prompted by negative rates in the euro area and elsewhere.
That said, existing strong USD positioning, potential risk aversion impacts (should the Fed make a policy mis-step, China/EM downsides or a complete commodity price collapse) and Fed attitudes continue to represent potential barriers to substantial USD upside. EURUSD seems unlikely to again substantially challenge the 2015 lows under 1.05 until expectations of further ECB easing and Fed tightening get further priced in which seems likely to take some time, so continued range-bound trading seems likely near-term (see here) albeit with downside risks more elevated than pre-Fed. But near-term USD upside against commodity and exposed EM currencies seems more likely. USDCAD has been rallying to 11-year highs on the combination of oil price weakness and expected Fed-BoC policy divergence (with Poloz doing a bit of cheerleading for CAD weakness in light of their negative terms of trade shock), so 1.40 looks feasible near-term (especially if Canadian inflation disappoints tomorrow). And I continue to believe that “buy the rumour, sell the fact” arguments about impending USD weakness are wide of the mark given the substantial differences of the current situation to previous Fed rate hike periods (see my substantive analysis from the Summer). Hopefully with the uncertainties about the first Fed hike fading the focus can shift more towards analysis of the current siuation rather than mechanical extrapolations of dated evidence.
So overall the next few months seem likely to be characterised by a modest bond bear market, probably led by 2-5 year yields, and a limited USD bull market. Of course this will all be data-dependent. But the market seems overly-fixated on downside inflation scenarios (I remain a bit sceptical, but less so than the market). And given the fairly-modest Fed growth expectations it’s hard to see them shifting from their currently-anticipated four rate hikes in 2016 to the two priced by markets. Yields seem likely to rise and USD supported even if the Fed meets the market half-way with three hike in 2016 (my base case), especially in an environment where the risks are skewed to further easing by the ECB and most other central banks (except BoE) and commodity producers and indebted EM countries continue to look vulnerable.
Optimistic Fed sticking to the script
The overarching point to take from the Fed last night was that the FOMC seems pretty assured about the US outlook. Specifically, Yellen argued that the liftoff decision reflected confidence about the strength of the US economy, the need to take account of the delayed impacts of rate changes and the “stitch in time” argument that a timely/prudent rate rise reduces the likelihood of future sharp rate rises which would derail the recovery. The the BoE may be taking note of the latter argument (see here). Indeed, Yellen followed up that the previous tendency for recoveries to peter out often reflected such tardy tightenings: she though it was a myth that expansions die of old age. And the Fed’s EM-related concerns have fallen by the way, such that the risks to the outlook are now balanced.
It was also notable that the rate hike decision was unanimous. And that the “dot plots” were revised down less than expected: while some individual dots did fall the median rate expectations little changed. The unchanged 1.375 median end-2016 Fed Funds projection implies that the Fed continues to expect to raise rates four times next year, versus only two hikes price by markets. Indeed, the 2016 GDP projection was actually revised up while the 2016, 2017 and 2018 unemployment projections were all shifted down. But in general Yellen passed up opportunities to sound dovish e.g. when asked about credit market concerns she instead stressed the soundness of the financial system and economic strength.
Initial positie market reception
The initial market reaction suggests that investors bought the Fed’s relative optimism. The combination of short-end sell-off (US 2y Treasury yields rose above the symbolic 1% level, while 10y yields were more volatile), modest across-the-board USD appreciation and US equity price bounce speaks of a upgrade to US growth expectations (although the SPX bounce unwound a bit today ). That positive market reception probably in-part reflected the Fed arguing that the pace of rate hikes will be “gradual” (implying less regular rate hikes than “measured”). Plus Yellen stressed, as I expected, that policy remained accommodative despite the small rate rise.
Greater focus on actual inflation
The Fed is also sticking to the view that current low inflation reflects the impacts of transitory factors (oil price falls and USD strength depressing import prices) whose impact will (quite quickly) fade, with a subsequent inflation uptick supported by a tightening labour market. One of the most notable developments was the greater focus placed on actual inflation in tracking progress, now on an equal footing to inflation forecasts (the Fed “will carefully monitor actual and expected progress towards its inflation goal”). And this innovation may end up increasing the volatility of rate hike expectations (as market analysts spend even more time interpreting every twist and turn of inflation outturns).
That said, Yellen clarified that this didn’t mean that inflation would have to be close to 2% for them to hike again. But she did express limited concern about survey-based inflation expectations, although she attributed (superficially worrying) moves in inflation breakevens to risk/liquidity premia variations (although that doesn’t necessarily explain why they’ve been more correlated with oil prices than euro area breakevens, see here).
But with the market apparently focussed on downside inflation risks (it took an hour of the press conference before anyone asked about upsides) the bar for upside inflation surprises and hence further Treasury sell-offs (and USD support) probably isn’t that high. Indeed, it’s notable that the Fed’s unemployment forecast conveniently smooth pastes towards the natural rate, in contrast with the previous overshooting tendency (although the prompt Fed action hopes to address precisely this). Yellen also pointed out that they only need oil prices to stabilise for base effects to support inflation. And she scotched the idea that they weren’t taking potential model-breakdowns seriously (is any investment bank investing as many resources as the Fed in its inflation modelling?). And the Fed hasn’t set itself an overly-arduous bar for further rate hikes on the growth side of its mandate. Forecast GDP growth of 2.4% in 2016 seems eminently-achievable.
No “buy the rumour, sell the fact” dynamics thus far
Thus far there’s been no sign of the “buy the rumour, sell the fact” dynamics that a number of large banks have been trying to argue would characterise the Fed hike. I’ve been repeatedly stressing since the summer (see here) that the large differences between the current situation and that around previous Fed hike periods renders such mechanical extrapolations inappropriate (even if it’s pretty easy to produce nice-looking charts). Without repeating my previous analysis, previously other central banks were often getting ready to hike (so rate differentials didn’t support USD even though treasuries continued selling off after the rate hike), oil prices were often rising (exacerbating US current account worries), USD was sometimes a funding currency and capital was sometimes flowing out of the US. The reverse is currently true in each case (see the charts below). So the hope is that, with the concerns about the first hike fading, deeper analysis will supplant easy chart plotting and spurious extrapolation.
Positioning, risk appetite and Fed attitudes to USD constrain major USD rally
That’s not to argue that positioning is unimportant. Indeed, the fact that USD upside is a consensus trade, with substantial existing long positions, is an important constraint on substantial USD upside. But it can be overwritten by upside news on US activity and inflation: and as noted above the market seems to be pricing relatively-low inflation outurns.
A further potential constraint on USD upside is the potential for risk appetite to be damaged – which would support funding (and safe haven) currencies like EUR, JPY and CHF and hit USD (illustrated by USD’s positive correlation with equity prices). Of course, the perceived ability of the US economy to handle the rate hike (and USD upside) will be important here: risk appetite would likely be hit if the market started to think that the Fed was making a policy mistake by hiking too quickly. This is where the Fed’s planned four rate hikes could potentially run into issues down the line. That said, they’d only go ahead with that if the US economy had improved satisfactorily and I’m relatively confident that the Fed will handle this deftly (rather than making a policy mistake). But developments in China, emerging markets (potentially caused by Fed hikes), commodity markets and the Euro Area (inadequate policy response) also need to be carefully monitored.
Finally, the Fed could again yet become more agitated about USD strength should it accelerate strongly – such feedback onto policy represents a natural break on USD strength. But it was notable that press statement etc didn’t expand upon existing worries about USD strength.