Fed: Tightening cycle well and truly under way - Natixis

Research Team at Natixis notes that the US Federal Reserve has raised its benchmark interest rate for the third time... in a decade as the Federal Reserve’s stance has clearly turned more hawkish, but the question is just how many times the Fed Funds rate will actually be raised this year.

Key Quotes

“Our expectations: monetary tightening to accelerate in 2017, followed by a further tightening and balance sheet normalisation in 2018.”

“Following the tweaks in the Fed Reserve’s wording, we have revised our monetary policy scenario. We expect a total of four interest rate hikes this year. While the timing of the next hike is in line with the market (i.e. expected in June), the latter still prices in only a total of three interest rate hikes this year. In 2018, the monetary tightening is expected to be achieved through further interest rate hikes (three in total) as well as a normalisation of the Federal Reserve’s balance sheet. Announcements concerning the latter will have to be monitored closely, with the risk of a selloff at the long end if ever the Federal Reserve surprises the market. Similarly, while a conventional monetary tightening through the short end would be expected to lead to a bear flattening, a balance sheet normalisation would be expected to create the conditions for bear steepening. In other words, the mix of the upcoming monetary tightening will have a crucial bearing on the slope of the yield curve.”

“Note also that our scenario presupposes, at this stage, that there will be no change in the composition of the Federal Open Market Committee (FOMC). In fact, a change at the head of the Federal Reserve is very likely in 2018. Three seats will become vacant this year, possibly another two next year when the terms of office of Janet Yellen and Stanley Fischer end.”

“Market reaction was very muted as the move was well prepared. Bond curve bull flattened a bit as some market participants expected higher dots pushing the dollar lower (one figure against euro) while MXN hit a fresh new high this year. The reaction by emerging markets is likely to be limited. The monetary tightening will be gradual, while the Fed Funds rate trajectory has been mapped out. What was seen as a threat has now been well integrated: post-Trump and ahead of the December interest rate hike, there were significant capital outflows from high-yield emerging markets. By contrast, there has been no letup in capital inflows into emerging countries in recent months, investors being attracted by the favourable growth differential (according to IIF, growth expected to accelerate from 6.4% in January to 6.8% in February, when our own estimate for developed countries is for growth of only 1.7%) and the incomparable carry.”

“All in all a good job by the FOMC which is now officially into a normalisation cycle (2 rate hikes in 3 months and 2 maybe 3 in our view to follow this year) without triggering much concern in markets.”