06.11.2017 - Fed stays on course for rate hike in December

 non-periodical

Key take-aways:
•    Improved assessment of the economy
•    Influence of hurricanes on economy and inflation assessed as temporary
•    Monetary policy orientation still seen as accommodating
•    Further interest rate hikes continue to be considered a necessity

Market reaction:
The US dollar reacted to the interest rate decision with a slight appreciation against the euro and gained 0.2 cents to 1.161 EUR/USD. US government bonds came under slight pressure across all maturities. The yield of the 2-year bond increased by 1 basis point to 1.61%, while the yield of the 10-year bond gained 2 basis points to 2.37%.

Summary:
As expected, the US Federal Reserve left the range of the key interest rate un-changed at 1.00% to 1.25%. The decision was unanimous. Randal Quarles who has been a member of the Fed’s Board since mid-October attended the interest rate meeting for the first time. The opinion accompanying the interest rate decision hardly differs from the one issued in September at all. The statements made back then regarding the likely effects of hurricanes Harvey, Irma and Maria were repeated. The central bankers do not assume that the hurricanes will have a lasting dampening effect on the economic development. On the contrary, the statements regarding the economic development were even more optimistic than six weeks ago. For instance, it was stated that the economy had been growing solidly most recently despite the negative impact of the storms. It was added that while the inflation rate had increased noticeably in the short term due to higher fuel prices, the inflationary pressure was still low without taking energy prices into account. The risks for the short-term economic outlook were characterised as roughly balanced once again.

Assessment:
The result of Wednesday’s interest rate decision was in line with our expecta-tions. The currency watchdogs seem to be satisfied when it comes to the economic devel-opment as well as the labour market. In fact, the description of the economic development as solid is the most positive assessment in a year. At the seven previous interest rate meet-ings, the growth of the economic performance was described merely as “moderate”. The Fed continues to be highly confident that the inflation target of 2% yoy, as measured by the deflator of private consumption, will be attained in the medium term. We share this view and would go even further. The unemployment rate ought to fall markedly below 4% in the course of 2018 and the inflation rate is likely to increase to more than 2% yoy in the third quarter, following a decline in the first quarter due to base effects. Contrary to the beginning of 2017, the inflation rate should then remain at an elevated level in the long term. In addition to the elimination of inflation-dampening base effects in the spring of 2018, the noticeable depreciation of the dollar since the end of 2016 as well as the oil price increase (for both Brent and WTI) of approximately 30% since mid-2017 are factors suggesting such a sustainable rise in inflation.

We therefore assume that the key interest rate will be raised in December. The Fed made it clear once again on Wednesday that it would look beyond weak economic data caused by the hurricanes. The fall in employment in September did not impress the central bankers because they know that the October report to be published on Friday will show a strong countermovement in non-farm payrolls – a plus of approximately 300,000 seems likely. On the other hand, the members of the FOMC obviously found it remarkable that the real gross domestic product grew so strongly in the third quarter despite the hurricanes. The prospects for the ongoing quarter are very good as well. In 2018, the Federal Reserve is likely to raise the key interest rate by at least 75 basis points. In case President Trump and the Republicans succeed in realising a corporate and/or income tax reform including significant tax relief after all, this would result in economic upside risks in 2018 and/or 2019 which could also lead to a faster normalisation or stronger increase of the key interest rate.

We believe that the economic conditions for a number of further interest rate hikes will be met in 2018. Furthermore, there are good arguments suggesting that the key interest rate will actually increase as envisaged by the members of the FOMC in the end. For instance, the shift of the regional Fed presidents will see two very “dovish” monetary policy figures – Charles Evans and Neel Kashkari – lose their voting right. They will be replaced by Loretta Mester and John Williams, both belonging rather to the “hawkish” camp.  Particularly great weight is currently attached to the regional Fed presidents as three of the seven board positions (that always authorised to vote) are still vacant.

Recommendation:
In all likelihood, the market has priced in an interest rate hike in December by now, as measured by the Fed Funds Futures, but there is still a lot of doubt about the schedule communicated by the Fed beyond that point. Much more than one further interest rate hike by the end of 2019 is not deemed likely. Given the expected development in the labour market and the inflation rate, however, the market will probably be unable to keep up this point of view in the medium term. As an interest rate hike in December is now generally expected, as described above, and the inflation rate ought to fall clearly below 2% by the spring of 2018, though, we see no further potential for a yield increase in the short term yet. The yield of 2-year and 10-year government bonds is likely to hover around the current level in the next few months.

 


 
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Warnings:
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Bonds

Financial Instruments/Companies

Initial publication date of the recommendation

10Y US Treasury

01/01/1989

 

Distribution of short term recommendations (preceding 3 months prior to this publication)

Recommendation

Basis: all analysed Government bonds

Buy

32%

Hold

41%

Sell

27%

Not rated

0%



History of short term recommendations (preceding 12 months prior to this publication)
 

Date

2J US Treasury

10J US Treasury

21.09.2017

Hold

Hold

25.08.2017

Sell

Sell

02.06.2017

Sell

Sell

26.05.2017

Sell

Sell

07.04.2017

Sell

Sell

10.03.2017

Sell

Halten

03.03.2017

Sell

Halten

13.01.2017

Hold

Sell

16.12.2016

Hold

Hold

25.11.2016

Hold

Hold

11.11.2016

Hold

Hold

23.09.2016

Sell

Sell

05.09.2016

Sell

Sell


Source: RBI/Raiffeisen RESEARCH

 

 

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