#Investments — 27.07.2017

Fed: Summer Break, See You In September!

Edouard Desbonnets

The Federal Reserve kept interest rates steady and said it intends to unwind its balance sheet “relatively soon”.

Taking into account the recent inflation figures and the difficulty of the Trump administration in passing reforms, we no longer anticipate another rate hike before year end. We however continue to expect three rate increases next year, with the first one coming in March.

Before The Fed Meeting

Inflation came out below target over the last few months, in May, core inflation weakened to 1.4% from 1.75% at the end of last year. This did not stop the Fed from hiking rates in June, considering inflation weakness to be temporary. An interest rate increase was therefore justified as growth was solid and the labour market was tight.

The Fed’s USD 4.5Tr balance sheet unwind is the other important story for the coming months as the impact on medium and long yields will not be marginal. The Fed already revealed that it intends to reduce reinvestments, without saying by how much and when.

The Fed Decision

As widely expected, the Reserve did not make any change to its monetary policy. In the absence of a press conference, investors only had the Fed’s statement to chew over. It was analysed in relation to two subjects of particular interest: how the Fed would qualify inflation, and any further detail on balance sheet shrinkage.

The FOMC discussed the weakness in inflation, acknowledging it had been persisting since the beginning of the year, and opening the door to a pause in the rate hike cycle.

Regarding the balance sheet unwind, investors will have to continue to wait as no new elements were revealed.

Due to the difficulty of the Trump administration in implementing structural reforms (Obamacare, tax reforms), and especially following weaker-than-expected inflation, we do not anticipate another interest rate increase before year end. We maintain our expectation of three rate hikes for next year, with the first in March. Regarding the balance sheet reduction, which is less linked to inflation data, we think Janet Yellen could make the announcement in September, with effect in October.

Initial Market Reaction

The status quo was largely expected, but market interpreted the statement as somewhat dovish on the rate outlook, which pushed US yields lower and the EUR/USD higher. The 2-year yield lost 2bps to 1.36% an the 10-year yield dropped by 4bps to 2.29%. The EUR/USD reached 1.17. US stocks closed at record highs, also driven by upside surprises on companies’ earnings: Dow Jones up 0.45%, Nasdaq up 0.34% and S&P up 0.03%. Oil prices were not impacted by the Fed. Futures indicate that European equity markets should open slightly up.