#Market Strategy — 22.03.2018

Fed: Consequences Of The Headwinds Shifting To Tailwinds

Edouard Desbonnets

The Fed increased rates by 25bps and signalled a steeper rate path as outlook strengthened


Before the Fed meeting

Lately, Fed officials have been vocal on the strong economic momentum. Powell, the recently appointed Fed Chair, told the US Congress a month ago that headwinds had shifted to tailwinds. The stimulative fiscal policy and firm demand for US exports being the new economic drivers. Even Lael Brainard, the most dovish governor of the Fed Board, echoed that thought, which suggested that the FOMC could speed up the pace of rate hikes. On the flip side, current inflation data is preventing the Fed from turning considerably more hawkish.

The decision

Not too surprisingly, given that the market’s implied odds were as high as 100%, the FOMC decided to increase the Fed funds rates by 25bps to the range of 1.50-1.75%. The vote was unanimous.

The Fed’s decision to raise the economic forecasts and accelerate the pace of rate hikes was less consensual. In detail, even though the Fed continues to expect three rate hikes in total this year, we could conclude it’s heading for four hikes as two Fed officials, very probably non-voting members, held back the median rate. For 2019 and 2020, the Fed indicated an accelerated path for rate increases and now expects three hikes in 2019 (vs. the 2.3 stated in December) and two hikes in 2020 (vs. 1.5 previously). The longer term rate was revised slightly up to 2.875%.

Powell tried to downplay the changing forecasts, emphasising that they are individual predictions to be read as a tool indicator and not a policy or target.

Anyhow, this new path for rates fully reflects the change in overall economic forecasts. The Fed revised 2018 and 2019 growth up to 2.7% and 2.4% respectively due to the meaningful demand boost from the fiscal policy, while revising down the unemployment rate for this year and beyond. Growth forecasts for 2020 and beyond were left unchanged, which indicates that the Fed is sceptical on the long term benefits of tax cuts. Inflation is seen to move up and stabilise around 2%. That projection is fairly similar to the one made in December.

Powell acknowledged that risks to the outlook appear roughly balanced. In addition to asset prices, he cited trade as a new risk as some Fed members feared retaliation following the new tariffs on steel and aluminium.

Initial market impact

This first FOMC meeting under Chair Powell was hawkish. Yet, Powell succeeded to raise rates, signalling to the market a faster pace of rates without generating a massive sell off. After choppy trading, equity markets dropped with the S&P 500 down by 0.18%, while yields edged slightly lower. The 10-year Treasury yield dipped to 2.88% and the 2-year yield lowered to 2.30%. The dollar weakened against the euro to 1.234. The dollar index dropped 0.8% as the market has been repricing towards three additional rate hikes this year.

Powell’s style is more blunt than his predecessor Yellen but the message remains the same: the Fed is on its way to normalising monetary policy by raising rates and reducing its balance sheet.

Our view is that the Fed will hike four times this year given strong economy and signs of inflation. We however expect only one rate hike next year as the economy should decelerate. The terminal rate would therefore be 2.75%.