#Market Strategy — 22.09.2016

The Fed Decided To Leave Rates Unchanged But The Devil Is In The Detail

Guy Ertz

The Fed decided to leave the policy rate on hold at 0.25%-0.50%, as expected. The tone was hawkish though, to signal to the market that a hike before year-end is very likely. The effect on markets was fairly limited after the announcement as the decision was already priced in. We maintain our yields forecast (10-year yield target at 2.00% in 12 months) and dollar forecast (EUR/USD target 1.08 in 12 months).

Before the Fed meeting

Fed officials were divided on the question whether they should hike or not as soon as September. This actually reflects the recent mixed macro data. On one side, activity indicators have slowed, so have the run rate of payrolls, and inflation expectations are still below the Fed target. On the other hand, the labour market is strong, wages increased and household income surged. Added to this, the balance of global risk is tilted to the downside.

The market already chose its side. It saw little scope for a rate increase as the Fed funds futures suggest no hike this year and only one by the end of next year. The market-implied odds of a rate hike were as low as 22%.

Considering the economic activity, does the Fed feel confident enough to hike ahead of the US presidential election?

In late August, at the Jackson Hole symposium, the Fed Chair stated the environment to be improved and the case for a rate hike strengthened. However, recent macro data (ISM Manufacturing, retail sales, industrial production) have not been strong since then.

The Fed decision

The Fed answered the question yesterday night and decided not to hike rates right now. Members chose to wait for more evidence of progress. Three members out of ten disagreed and were in favour of a hike now. Such dissention is quite unusual and reflects the complexity of the verdict. Despite that decision, Fed Chair Yellen gave a hawkish speech, stating that the near-term risks to the outlook are roughly balanced. She clearly signalled to the market that a hike before year-end is still on the table if there are labour gains and no new risks.

The FOMC updated its summary of economic projections and its dot plots. It barely changed its forecasts regarding GDP, unemployment and inflation, but sharply revised down the Fed funds projections to 0.60%, 1.1%, 1.9% and 2.6% for 2016, 2017, 2018 and 2019. This represents a downward revision between 0.3% and 0.5% compared to June projections. The longer-run Fed funds were also revised down to 2.9% from 3.0% in June.

This gives comfort to our view and we maintain our forecast of one rate hike in December and two more in 2017.

Initial market reactions:

The decision not to hike rates was expected by the market so the market reactions were limited.

US 2-year yields, which tend to be the most sensitive to the Fed policy, lost 3 bps after the announcement to close unchanged at 0.77%. 10-year yields finished the day about 4 bps lower at 1.65%.

The dollar gained about 0.3% against the euro to 1.12. More interestingly as we had both the Fed and the BoJ meeting today, the dollar weakened against the yen by 0.4% to 100.22.
US stock markets closed higher, gaining 1%, and energy and banks stocks rallied.
Commodities also finished higher.
Futures markets indicate that European equities should open in positive territory.