The Federal Reserve’s December meeting – a giant anti-climax?

In the post-election world, it is worth asking whether the Fed meeting this week will be particularly significant, given that attention is now focused on Donald Trump and the policies of his new administration. A 25-basis point rate increase is now so widely expected that it is difficult to see a particularly bullish path for the US dollar. 

For weeks now, the probability of a rate increase at the Fed’s December meeting has sat at 100%. Having waited twelve months since the last rate hike, investors are now convinced it will happen. As is so often the case in markets, this outcome is now largely factored in. The US dollar has risen by almost 4% since the early days of November, and a brief dip last week was met by fresh buying.

A desire to avoid being labelled politically motivated is likely to mean that Janet Yellen will opt to say little (if anything) about the new US administration. Indeed, it will almost be as if the election has not happened. 2017 could be the year when infrastructure stimulus comes to the US, and when inflation returns, but Ms Yellen will not want to stray on to those topics. Instead, she will confine her broad remarks to monetary policy and the current state of the US economy. While jobs growth is strong, and the unemployment rate remains below 5%, there are still reasons for concern.

Wage growth has slowed to 0.9%, less than half its high in 2015, when it hit 3%. With the US dollar at multi-year highs, US firms will be worrying about the impact the currency will have on overseas earnings. This is a reverse of the positive impact enjoyed since Brexit by international firms listed on the FTSE 100; sterling’s weakness has boosted earnings. Dollar strength will hurt them, so the Fed will likely want to avoid sounding too hawkish on the path for rate increases, lest investors try to front-run the Fed by pushing the dollar higher into the open months of 2017. In addition, weaker wage growth could see earnings start to fall for US workers squeezed by inflation (if prices go up by 5%, and wages by 2%, then real incomes fall).

Indeed, while inflation is a potential worry for the coming year, the Fed will be acutely aware that the rise in the US dollar since its nadir in May (up almost 10%), has been the equivalent of several rate increases. A rising dollar sucks money from emerging markets, weakening their economic performance, and this in due course comes back to hurt the US.

The long-term impacts of the Fed’s tightening will become clear in due course. For now, we should look at the potential market impact. Unless Janet Yellen comes out extremely hawkish, pencilling in more rate hikes next year than the market expects, then we could see further USD weakness in the near-term, perhaps moving back below the 100 mark for the dollar index. 

A key FX pair to monitor will be USD/JPY. This has shot higher since its low formed during the summer, but appears to have run out of steam below ¥116. A cautious Ms Yellen could result in some of this move reverse, retaining the new uptrend but dropping back towards ¥111.44 or even ¥107. 

US stock markets have been resilient, and a weakening dollar may not bring them back to earth too quickly. However, caution over the outlook could see some money shifted away from US stocks, and the S&P 500 will be the main index to watch here. With the market trading around an all-time high, sentiment and investor positioning is quite vulnerable to a sudden drop that accelerates quickly.

The proximity of Christmas, and the usual festive rally that results, could mean that a reckoning is delayed until the new year. With earnings due from early January, the new year could get off to a difficult start.

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