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In a nut-shell, interest rate traders are saying a hike is effectively a done deal and to move along. In truth, the market is right, as the Federal Reserve (Fed) have been guiding market participants to believe they have always wanted to hike in December - they just need a little bit more information, which they now have. So the question everyone should be asking is how many times they raise in 2017 and 2018 and, most prominently, what is the longer-term (or ‘terminal’) federal funds rate?
By way of a guide around current market pricing, and if we include the December meeting, the interest rate markets are now pricing 2.6 hikes through 2017 and 4.3 through 2018. Prior to the election, the market had priced 1.7 hikes through 2017 and 2.4 through 2018.
The results of the US election was one of the most breath-taking sell-offs in developed market bonds that we are ever likely to see, with the US treasury yield commanding an ever-greater premium over the likes of the Japanese or German bond markets. Of course, this widening yield differential was always going to make the USD more attractive and as such, we have seen the trading community rush into this one currency. Still, despite the trade-weighted USD hitting a 14-year high and US bond yields spiking, in turn pushing US 30-year mortgages closer to 4% (they were 3.5% pre-election), we haven’t really seen any stress in global equities or the corporate credit markets. Oil prices look to be heading back to $50, courtesy of a new-found belief that we may actually see supply cuts from OPEC at its 30 November meeting. Emerging markets assets, after initially selling off when we learned of the Republican clean sweep, have found stability and are actually attracting buyers again.
The Fed will be inspired by the lack of any concern in this markets, and they will be especially pleased with the US volatility index (‘VIX’) being at such subdued levels. For the first time since 1999, we have simultaneous record highs for the S&P 500, Dow, NASDAQ and small cap Russell 2000. They have regularly told market participants that they were not a political organisation, and to be fair, they had been expecting fiscal stimulus from either Trump or Clinton, but perhaps in differing forms (Trump through tax cuts, Clinton through increased spending). It seems logical that they would have taken this expected fiscal stimulus into account in recent narrative.
Still, the conversation in markets has moved onto whether the fiscal stimulus from the Trump administration (whatever the make-up of this administration looks like) will force the Fed to be more aggressive in tightening monetary policy longer-term. It’s this aspect that traders and economists will be focusing on most intently in Janet Yellen’s press conference after the Federal Open Market Committee (FOMC) meeting.
In my opinion, the USD is in the midst of multi-year bull market that really started in 2014. While the USD has rallied some 25% during this time frame, if US inflation expectations continue to push US bond yields higher, and political instability increases in Europe amid loose monetary policy still very much in place in Europe, Japan, and the UK, it seems highly likely the USD is only going one way over the next couple of years. Whether that becomes a bigger issue for the Fed is something we’ll have to see, but for now, it’s not weighing on market sentiment to any great degree.
As always, it is wise to listen to Janet Yellen, as she will make it perfectly clear if the Fed are nearing a point when the rampaging USD is affecting its inflation forecasts. The degree of concern from the Fed chairman will be the cue for all traders to work from. One aspect I am cognisant of is whether we see a ‘buy the rumour, sell the fact scenario’ play out in markets like the USD, gold and US treasuries.
Some event risks to consider through late November to early December:
- 30 November – OPEC meeting. Will they allocate agreed production cuts?
- 4 December – Italian referendum on Senate reform. Will Eurozone political concerns ramp up?
- 4 December – A re-run of the April Austrian election which was annulled after irregularities with the original vote count.
- 8 December – European Central Bank (ECB) meeting. We get new economic projections, but will we hear about an extension of ECB’s QE program?
- 14 December (15 December at 6am AEDT). FOMC and Janet Yellen press conference. With markets fully pricing a rate hike, will we see a ‘buy the rumour, sell the fact’ scenario play out in the USD and US equities?
- 15 December – Is another cut from the Bank of England on the cards?