Yes a Rate Hike is Likely, but Wait, There's More

After much hemming and hawing since mid-year, the Federal Reserve is finally poised to raise rates for the first time within nearly a decade. Indeed, given the speeches by the leadership and also the economic data, especially the labor market readings, the failure to raise rates would likely be more destabilizing at this juncture than raising them. 

Surveys of market individuals suggest that a Fed backpack is as done of a offer as such an event can be. A recent Reuters survey found all but 1 primary dealer expects a hike this week.   A Wall Street Journal poll found 97% of professional and academic economists also expect the actual Fed to raise rates now.    That is a five percentage stage increase from last month and 10 from October. 

It appears that many are looking past the decision itself.  The FOMC statement's financial assessment is unlikely to change very much.  The economy is performing mostly in line with its expectations.  In this context, we note that following retail sales and inventory data, the Atlanta Fed'utes GDPNow tracker has Q4 GDP growing at 1.9%, up through 1.5% the previous week.  This really is generally thought of as trend development for the US, given the reduced productivity and labor force growth. 

The Fed has been at pains to drive home two suggests investors.  First that the pace of rate increases expects to be gradual and it will be dependent on the evolution of economic activity.  In September, steady was operationally defined by the dot-plots as 25 bp a quarter (almost every other meeting) in 2016 and 2017.  The marketplace will be looking at the new predictions to see if this is still the actual Fed's thinking.  A few investments houses, and Fitch, the rating agency, have also forecast 4 hikes next year. 

The second stage Fed officials have anxious and it will likely to be repeated after the new FOMC statement, is that the terminal rate or the peak in the Fed funds target will likely be lower than in past cycles. Again, the dot-plots suggest that officials expect the Fed money to peak near 3.75%.  The market, as reflected in the Fed funds futures and OIS market expects considerably reduce rates.

In the past, the real Fed funds (adjusted for rising cost of living) had to be near zero or even below, before the US economy recovered from a recession.   Within this expansion, the market does not expect Fed funds to be positive in real terms.  The suggested yield of the December 2016 Fed funds futures contract is actually 77 bp.  The 12 , 2017 contract implies 127 british petroleum and June 2018 is at 147 bp. 

A significant challenge to using the actual Fed funds futures contracts to interpolate expectations of Fed policy is that the contracts negotiate at the average effective price for the month, not the insurance policy rate. Now that Federal Reserve has adopted a target variety for the Fed funds price, it is an open question of where Fed funds may average after a hike.  In the zero-bound (current target range is actually 0-25 bp), the Fed funds have averaged around the mid-point of the variety 12-13 bp.

What Fed funds typical after lift-off is an open query.  Many popular models simply assume that the midpoint achieved typically.  However, to drive home the purpose of gradual hikes, and to maximize the attractiveness of interest on excess reserves, which did not exist before the crisis, suggest the risk sufficiently liquidity is provided through the Fed to keep the funds rate on the soft aspect of the midpoint. 

The Fed's dot-plots, which we argue, has a high noise to signal ratio, might be particularly important this week to help form expectations of the next backpack.  Bloomberg calculates that the March Fed funds contract are hinting about a 35% chance for a second backpack.  The Wall Street Journal polls found nearly 2/3 (65%) from the private sector professional economist expect the Fed to deliver the 2nd hike in March.  In November, only half (49%) expected a March hike.  An additional 14% expect the second hike to be delivered April (when the FOMC meeting is not accompanied by an revise in forecasts or a push conference).

One of the implications of the review is that, although the divergence meme is widely recognized, it is hard to determine that it has been fully discounted.   This underpins our moderate and longer-term bullish dollar perspective, but it does not stand in the way of a continuation of the near-term dollar correction.  Our review of the speculative positioning in the futures market indicated much to our surprise that the dramatic rally in the euro (and other currencies) in response to the ECB action failed to reflect a significant adjustment of short exposure. 

The price action and technical indicators additionally support this conclusion.  After rallying since the middle of October, the dollar's correction does not appear to be complete.  Year-end considerations, including the diminished participation and assets, may exacerbate the pain-trade of further dollar losses. 

In terms of the decision to hike prices itself, among the voting FOMC members there could be as many as three dissents.  This would include Governors Tarullo and Brainard, and Chicago Given President Evans.  All three have been vocal objections to a hike under current conditions.  A dissent by regional Fed president is actually commonplace; from a governor, less so.   A unanimous decision is actually preferable but seems decidedly unlikely.  However, fewer than 3 dissents may speak to Yellen's leadership skills.

II

The FOMC is the highlight, but there are five other essential developments that will help shape the investment climate:

1.  Before the weekend, The far east announced that it would place more emphasis on maintaining the actual yuan's stability against a gift basket of currencies rather than simply the US dollar.  Officials make similar pronouncements in the past; what it means in practice is yet to be seen.  The conclusion many have attracted is that this will allow the yuan to depreciate further against the dollar.  While we don't disagree with this assessment, we note that the yuan has steadily fallen from the dollar over the past six weeks.  Remember the dollar finished last week at four-year highs against the yuan before the statement.  It is as if China had already operationalized the policy and only agreed to be getting around to announcing it.  

The political and ideological chits earned by downgrading the role of the dollar are minor at best.  China is trying to spin the necessity as a virtue.  The US Treasury appears to have been one of the sustained sounds calling for the abandonment of the reliance on the dollar (and the accumulation of Treasuries that has implied).  Real money flows will still be relocated and liquidity transferred within bilateral currency terms, not the index that China might prefer.  When it does enter the SDR, it will still be providing the dollar-yuan rate to the IMF on a daily basis. 

The issue here is not really about the yuan's exchange rate or the dollar's worldwide role.  Instead, it is about China trying to de-couple from US financial policy as the Fed prepares to begin a tightening cycle.  The link between the yuan and buck is an important channel in which financial impulses are transmitted.  Because of the divergent needs, the linkages to US financial policy no longer serves China's interest. The conclusion of many international investors is that Chinese authorities botched the mid-August attempt. 

2.  Three other major central banking institutions meet in the week ahead:  Sweden's Riksbank, Norway's Norges Bank and also the Bank of Japan.  There is most confidence in the results of the BOJ meeting.  No change is expected.  The Riksbank and Norges Financial institution meetings are live, meaning that a change in policy is reasonable. 

The Riksbank deposit rate is set at -35 british petroleum.  While it could cut, all of us suspect it may choose to maintain its powder as dried out as it can be said when it is to date through the zero-bound.  At the same time, it could expand its bond-buying program by SEK5-SEK10 bln.  The actual euro had been trending lower against the krona but appears to have created out a bottom.  There’s scope a one-two percent recuperation of the euro of the subsequent couple of weeks. 

Whereas the Riksbank is concerned regarding deflation, the Norges Bank's challenge is with growth as the drop in essential oil prices reverberates through the economy.  The continued drop in oil prices along with a series of disappointing economic information may spur the Norges Financial institution to cut its deposit rate from 75 bp to 50 bp.   The euro is already sitting just below the actual year's high against the Norwegian krone.  Additional gains are likely. 

3.  Eurozone data includes the flash PMI, October'utes industrial production and last read of November CPI.  Using the ECB out of the picture, given the recent action and the completion of the actual December TLTRO, the economic data might lose some of it market-moving potential.   You will see some allowances also designed for some softer sentiment information, including the German IFO, for disruptions following the October 31 attack. 

There are several UK economic reports in the week ahead.  These people cover prices (CPI and Payment protection insurance), consumption (retail sales) and the labor market.  CPI is near enough to zero to not matter very much whether it is in addition or minus a little; it’s the same thing for all practical reasons.   While the labor market expects to be little changed, confirmation that the upward pressure on average weekly earnings is dissipating may be understood as further pressing out a BOE rate backpack, and weigh on sterling'utes exchange rate.  If the Bloomberg consensus is right that the year-over-year pace associated with UK retail sales decreases to 2.3% (excluding petrol), it might be the slowest pace in two many years. 

Japan starts the week with the quarterly Tankan Survey.  It is widely viewed as one of the most authoritative surveys of Japanese businesses.  The market wants little change to slightly softer results.  It is unlikely to have much impact, barring a substantial surprise.  Capital expenditures tend to be particularly volatile, and it is partly owing to capex that Q3 GDP was revised from contraction to expansion.  The capex plans documented in the Tankan survey may draw attention. 

In the middle of the week, Japan reports the November trade balance.  For the past eight many years without fail, the November trade balance was even worse than October and this 12 months is unlikely to break the seasonal pattern.  Indeed, after the six-month streak of trade deficit had been snapped in October, chances are it will have reverted to a deficit within November.  More important than the balance is the performance of exports and imports.  Merchandise exports fell 2.2% in October (year-over-year), the first decline within August 2014.  They expect to have remains negative in November.  Imports get the decline in power and commodity prices.  Because of the base effect, the decrease is moderating. 

4.  The market has improved the risks that the Bank associated with Canada will deliver an additional rate cut in late-Q1 or early-Q2.  Traders will likely respond to data through looking through such a lens.  Since December 4, the implied yield of the June Sixteen BA futures contract has fallen by about 17 british petroleum.  The Canadian dollar is the worst performing major currency this year, losing about Fifteen.5% so far.  Its 3.2% reduction thus far this quarter can also be the most among major currencies.  The same is true of its 2.8% decline here in December. 

The decline within oil prices, the increasing US interest rate premium, and weaker equity markets align the fundamentals against it.  Also, the macro-prudential measures the government announced prior to the weekend (raising required deposit on home purchases of more than C$500k) is seen, on the margins, it increase the risk of a rate reduce by removing a potential hurdle (overheating housing market). 

5.  While it might be tempting to link the emerging market sell-off to the potential customers of Fed tightening, we argue it is considerably more complicated.  The dollar's more than 10% move against the South African rand experienced less to do with what the US was doing and much more using the dismissal of a market-respected finance reverend, even as the country teetered on losing its investment grade status. 

The Brazilian real is the worst performing emerging market currency this year, losing nearly a third of its value (31.4%) against the US dollar.  While some small percentage this may be due to considerations about the US monetary policy perspective, the bulk is largely a product household politics and falling commodity prices, related to slower Chinese language demand.  

While we have expressed our doubts with the emerging marketplaces as an asset class, we have noted that a more differential look at is required.  This insight will be driven home in the days ahead when eight emerging market central banks meet.  Hungary, Philippines, and the Philippines will stand pat by nearly all reckoning.  There is a slightly greater risk that Taiwan and Thailand central banks ease coverage (note that Taiwan often moves in 12.5 bp batches). 

Colombia is most likely to hike prices.  It has done so in each of the past three meetings.  While there is a 50 bp backpack in October, the Bloomberg consensus expects a 25 british petroleum move as in September as well as November.  On the other hand, the dollar's 8.3% appreciation of from the peso since the rate hike make warrant a larger move.  Chile'utes central bank meets.  It hiked rates in October from 3.0% to 3.25%.  The Bloomberg consensus does not expect another hike. 

The outlook for Mexico's central bank is more controversial.  The weakness of the peso and official comments have fanned expectations that on the day after the Fed hikes rates, Mexico will do the same.  This is the Bloomberg consensus.  Given that the peso's weakness has not spilled over to increase prices, the urgency to follow along with suit is not immediately evident.

After ECB's Hawkish Cut, Is the Fed about to Deliver a Dovish Hike? is actually republished with permission from Marc in order to Market