It's not what the Fed did, it's what they're thinking .....

Thursday 15th December 2016

  

It's not what the Fed did, it's what they're thinking ..... even so, is that really so unexpected?

ref:- "Dollar Climbs to Strongest Since 2003 on Fed Path; Bonds Drop", Bloomberg Markets

The Bank of England have just announced that their monetary policy is to remain unchanged, a decision that was entirely expected. True, the British Pound that had been faring better than most against a rampant dollar gave up some ground on BoE Governor Mark Carney's statement. He said that the recent bounce in the value of sterling meant that inflationary concerns might be slightly less severe than feared (the implication being that rates might therefore rise less steeply). But in the greater scheme of things, it was hardly a "significant market event".

You could not say the same thing about the US Federal Reserve's decision last night ..... or rather about what was revealed with regard to the Fed's thinking in the future. The Fed's move to lift rates by 25 basis points to a band of 0.50% - 0.75% was also entirely expected, but what's grabbed the market's attention is that the so-called "dot-plot", which maps out the rate forecasts of the individual FOMC policy makers, reveals that the mean average of the forecasts points to three more 25 bp hikes in 2017  --  up from the two that they thought likely at the last meeting.

Cue heavy dollar buying and sharp rises in bond yields. At a smidgen above 1.0400, Euro / USD has broken a near 14yr low.  USD / JPY, which traded below JY100 at the end of the summer, is now above 118.00. Two days ago claxons were sounded when the yield on the 10yr US Treasury hit 2.50%  for the first time in two years  --  earlier today it traded at 2.63%. Whichever way you look at it, this is big news.

And yet .... the change in the dot-plot that points to the Fed expecting three hikes in 2017 rather than two was definitely NOT a foregone conclusion, so a market reaction is certainly understandable. But neither was it a change totally out of left-field. It only required two members of the FOMC to upwardly revise their forecast to affect the average call. In the light of the implications for growth and inflation implicit in the new administration's likely fiscal stimulus, that hardly seems like a surprise development  --  especially given employment data that is already pushing capacity. Frankly, the strength of the reaction is a little surprising to us.

Mind you, the Fed has some dodgy form when it comes to this type of thing. This time last year, they forecast four hikes in 2016  --  in the event, they've managed to squeeze in just one. To be fair, they might point out that their reticence was as much dictated by global concerns as it was by domestic ones but whatever the case the market didn't believe them and fared rather better by predicting just two rises (as defined by futures market prices). As it happens, it doesn't believe them this time either and is forecasting just two again.

It's interesting, isn't it? Things are very different this time around and Mr Trump's fiscal strategy, and all that it brings with it in terms of inflation and rates, makes a case for dollar bulls and bond market bears that is hard to counter ..... at least, that's what's winning the argument just now. But nothing's quite that simple and markets can overreach themselves. It's always a good thing to keep an eye on oversold / overbought indicators, particularly when things get a little one-sided (as now, for instance). And remember the year just gone ..... going by all the basic fundamentals, there was very little reason to sell dollars / buy jap yen at the end of 2015  --  apart from the fact that broadly speaking USD / JPY had already been on the up for the best part of three years.

Was that the reason why USD / JPY fell about 20% in the first half of the year when most analysts were predicting continued dollar strength? Just a matter of timing? Or was it a particular set of global issues that prompted a flight-to-quality into the Yen? Maybe .... but those problems haven't gone away. In fact, if you look at Europe there are arguably more now than there have ever been. 

So have care ..... buying dollars does make sense, but there's a limit to everything and just because an argument is logical it doesn't mean that the outcome will be straightforward.