The Federal Reserve raised US interest rates for only the second time since 2008, as forecast, but the tone of the statement and press conference were hawkish, setting the scene for higher yields and even more US dollar strength.
The Fed raised rates for only the second time since 2008 at the Federal Open Market Committee (FOMC) meeting on 14 December to 0.75%, surprising absolutely no one, and yet it still managed to intensify the selloff in US Treasuries and cause the US dollar to strengthen even further. For a Fed meeting the outcome of which could not have been less surprising, these moves were unexpected in their strength. Five-year notes bore the brunt of the selloff, moving from around 1.89% to 2.05%, with yields managing to edge higher through the remainder of the week, though with the curve flattening somewhat. The US dollar strengthened against all the other major currencies, with the dollar index (DXY) reaching 102.90 by the end of the week, its highest since 2002 (see chart).
Exhibit 1: US dollar index 31/01/67 – 19/12/2016
Source: Bloomberg, as of end December 19, 2016
Setting the tone for more rate rises and more dollar strength
This was caused first by changes in the FOMC members’ forecasts – the ‘dots’ – which showed a move from two to three expected rate hikes in 2017. In addition, the median long-run neutral fed funds rate was moved back to 3%. Both of these are small changes and are thought to indicate less a change in the Fed’s thinking in aggregate than a signaling from some of the more influential FOMC voters as to their views on the likely path of rates, and that we should expect some of the other members in essence to catch up in subsequent meetings. It follows that this may be less a literal expectation of one additional hike than the beginning of a shift towards more rate hikes, coming more frequently.
From hesitancy to hawkishness
The statement itself was, as usual, an exercise not unlike the child’s game of looking at 20 objects, leaving the room, and returning to identify which one has changed. On this occasion though, while the framework of the text remained essentially the same, key phrases were added, including: “Market-based measures of inflation compensation have moved up considerably,” and “in view of realized and expected labor market conditions and inflation, the Committee decided…” Indeed, most of the phrases implying hesitancy or equivocation were removed leaving, by the admittedly muted standards of these things, an unabashedly hawkish tone.
Fiscal policy – no advice
Lastly, Fed Chair Janet Yellen gave the now-customary press conference. It was notable mostly for her gymnastic effort not to be drawn on commentary as to future fiscal policy almost immediately falling flat on its face at the hurdle of pro-cyclical infrastructure spending: “I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment,” with the immediate caveat that, “nevertheless let me be careful that I am not trying to provide advice to the new administration or to Congress as to what is the appropriate stance for policy. There are many considerations that Congress needs to take account of and many bases for justifying changing fiscal policy.” We await the change of administration and the Fed’s reaction to it was interest.
On the ball, not behind the curve
Of more immediate relevance to the path of monetary policy was in response to the suggestion that the Fed had wished to get behind the curve: “I do want to make clear that I have not recommended running a hot economy as some sort of experiment.” There has been a persistent assumption for much of 2016, arguably informed by previous Fed commentaries, that the Fed would be looking largely to wait until some form of equilibrium rate of growth and unemployment and crucially inflation had been reached before meaningfully increasing rates – as opposed to tightening commensurately with these developments so as to arrive at the supposed neutral fed funds rate in synchronicity with them. That Chair Yellen was so emphatic to the contrary really shatters this belief, and with it support for the idea this set of rate hikes might be different from previous hiking cycles to the extent it has not already been so.
What we are left with is the idea that rates have little support even at current levels, and that we should probably price more dollar strength. While the extent to which monetary conditions have already tightened through currency appreciation is considerable, the above Chart of the Week aims to put this in context: as Bachman Turner Overdrive put it back in 1974*: You Ain’t Seen Nothing Yet.