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Last night equities, crude oil and precious metals slumped while the dollar soared. These moves came after the US Federal Reserve raised its key fed funds interest rate band by 25 basis points to 0.50-0.75%. But it wasn’t the rate rise which roiled the markets as the hike was widely expected. Rather it was the change in forecasts by FOMC members for future interest rate moves - particularly over the next twelve months. The Fed illustrates these predictions in what is known as a “dot plot” in its Summary of Economic Projections. Analysts compared the Fed’s expectations from the last summary back in September to the ones released last night, and these can be seen below (with my annotations):

September 2016                                                                      December 2016

As I’ve tried to illustrate, FOMC members have raised their rate hike predictions for next year to 75 basis points from 50 basis points. Taken on its own this seems inconsequential. After all, does it really make that much difference  if the fed funds rate ends next year just below 1.25% or 1.50%? Not only that, but just how useful are the Fed’s predictions? This time last year the central bank forecast rate rises of 100 basis points in 2016. We ended with just 25. But taken together with Donald Trump’s election victory last month it suggests that a big shift is taking place.

In this regard there were a couple of things that Fed Chair Janet Yellen said in yesterday’s press conference which are of interest. In explaining the reasons behind the Fed’s tightening of monetary policy she said that some participants cited December’s unemployment number (which came in at a seven year low of 4.6%), a pick-up in inflation (both actual and expectations) and likely changes in fiscal policy. Yet straight after the election a number of Fed members said they would wait to see which fiscal policies were actually implemented, and to what degree, before considering them in decisions over monetary policy. During press questions last night Dr Yellen seemed unwilling to be drawn on fiscal policy and its link with monetary policy. Yet both she and her predecessor Ben Bernanke, have (like Mario Draghi over at the ECB) been banging on for years about how it was a mistake to rely on monetary stimulus alone and policymakers must step up to the mark with fiscal stimulus.

Of course, president-elect Trump made campaign promises to cut taxes, boost infrastructure spending and slash regulation. These are all pro-growth, pro-inflation examples of the kind of fiscal stimulus which, it would be imagined, is just what Bernanke and Yellen were calling for. A number of questions from the press asked if Dr Yellen was concerned about the risk of the economy overheating should Trump manage to push through tax cuts and stimulus spending. She said there was no obvious need for such stimulus as the US employment situation has improved recently, although in mitigation she said stimulus could help productivity.

But Trump’s stimulus could be a problem going forward. If it looks as if he can’t get it through Congress then the Trump Rally will unwind rapidly. But if it goes through we could see inflation expectations rise sharply and bond yields rally in response if investors gauge that the Fed is behind the curve when it comes to keeping a lid on inflation.

 Earlier today the yield on the key 10-year US Treasury bond jumped above 2.6% to hit its highest level in over two years. A rising yield means a falling bond price. What is particularly worrying about this is the pace of the rise since the summer as can be seen from this Bloomberg chart below. This suggests that many investors will have been caught on the wrong side of the move, and that’s a potential problem given how these debt instruments sit as collateral (which is falling in value) at the base of the global economy.

So keep an eye on the dollar. It could rise sharply from here if investors expect inflation to take off and interest rates head higher in response.


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Posted by David Morrison

Category: PM Bulletin

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