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US Fed Raises Short Term Rates

19 June 2017PoliticsEconomicsUK
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What Happened

The Federal Reserve (Fed) raised the target range for the Fed Funds Rate by 25 basis points to 1.0-1.25% as widely expected. It signaled one additional rate hike in 2017 followed by three hikes in 2018. The statement noted that the Committee expects to begin the process of balance sheet normalisation this year.

  • The median projection for the Fed Funds Rate at the end of 2018 remained unchanged at 2.1% while the Fed's assumption for the terminal rate stayed on hold at 3%.
  • The market is now pricing a 22% probability of a September hike and 42% for a December hike.
  • The Fed released a detailed plan for reducing the balance sheet. Initially, the balance sheet will be reduced by $10 billion per month ($6 billion Treasuries, $4 billion MBS). The amount will rise every three months until a final size of $50 billion ($30bln Tsy / $20bln MBS) is reached over 12 months.

Market Reaction

  • Market reaction was relatively muted as the move was widely expected. The S&P 500 fell 0.1% while the Dollar Index, a measure of the U.S. dollar to six major world currencies – was flat at 96.97.
  • US Treasuries moved higher, as the yield on the 2-year note declined 2 bps at 1.35%, while the yields on the 10-year note fell 7 bps to 2.15%.

What Lies Ahead

Citi analysts now expect the Fed's balance sheet normalization to be announced in September and for the next rate hike to take place in December.

  • Despite three consecutive months of weak inflation readings, Fed Chair Janet Yellen attributed the slow price rises to one-off factors. Nevertheless, Citi analysts believe that given the weak inflation readings, the Fed is under less pressure to hike rates again quickly.
  • Since Citi analysts believe that the Fed is unlikely to hike and announce balance sheet reduction at the same time, they now expect the Fed to start the balance sheet normalization in September and to hike rates next in December.
  • During the meeting, the Fed also revised down 2017's unemployment rate to 4.3% and revised up the real GDP growth rate to 2.2%. Inflation forecasts for 2017 were revised lower but forecasts for 2018's were unchanged at 2.0%. Citi analysts stress that the lack of inflationary pressure may keep the urgency of further tightening in check.

Investment implications

  • US dollar: Citi analysts remain optimistic and still expect tax reforms to be passed over the next 12 months. However, political developments could distract the US administration and prompt investors to look for better opportunities elsewhere until more clarity emerges. The USD is likely to be volatile in the short term but further Fed rate hikes can limit the dollar's downside.
  • Equities: The slow pace of Fed rate hikes is likely to remain supportive of equities, although Citi analysts see more attractive opportunities outside of the US, given relative valuations. In particular, contained USD strength, a slow pace of Fed rate hikes and improving economic fundaments are positive for Emerging Market equities. Given the broadening recovery in the Eurozone and reduced political risks, Citi analysts also see opportunities in European equities, especially European dividends.
  • Bonds: Citi analysts forecast 10-year Treasury yields to reach 2.2% by the end of 2017. Without any progress on US health or tax reforms, US long-dated yields are likely to remain range bound. Against this backdrop, Citi analysts find Emerging Market Debt attractive and continue to favour selected US financials as beneficiaries of rising rates and regulatory reforms. Given low yields and risks for tapering by the European Central Bank later this year, Citi analysts are more selective within European Investment Grade corporate bonds. They prefer core European financials which are expected to benefit from better macro trends, a recovery in earnings and stronger capital positions. The analysts have turned less positive on high yield bonds as credit spreads have tightened.

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