Fed to Still Follow, Not Lead, in 2017?

Posted December 19, 2016 by rvillareal

One year after initial liftoff, the Federal Reserve raised the target range for the federal funds rate to a 50-75 bps range. A decision that preoccupied markets for much of the year went off without a hitch. Indeed, incoming data and the outlook had finally improved to a point where markets could finally give the Fed an unequivocal green light in the wake of the U.S. presidential election—equity friendly, inflation-juicing, and bond unfriendly. In addition, the fact that short-term funding rates have been rising for some time helped to take the sting out of the move.

DE has been stressing an optimistic view of Trumponomics on growth and inflation in 2017, reinforcing our longstanding calls favoring the U.S. equity market, and a negative view on fixed income in an environment of rising rates. Given the pre-meeting comments by many Fed officials that it is still too early to put hard numbers on still-uncertain tax, spending, and regulatory reform in the pipeline in 2017, it wasn’t surprising they made only the smallest of changes to growth and inflation forecasts. The upward nudge to the dot-plot was read hawkishly, but is less than it seems given only two members need to marginally shift their 2017 views to imply three hikes next year, versus two hikes as of the September meeting.

If DE and markets’ initial assessment of the likely range of outcomes in 2017 and 2018 are in fact more probable than the Fed is willing to pencil in, we look ahead to a 2017 where the Federal Reserve continues to follow, not lead, the market (and DE). This time, to the upside. For the first time in years, market pricing implies a funds rate path in line with the median FOMC official over the year ahead, and holds only 25bps below the implied path at the end of 2018. Even that is understated, as market pricing tends to put more weight on downside tail risks relative to the “Baseline” modal path that Fed officials and economists tend to pencil in.

Lest we sound too Pollyannaish about the outlook, DE does note that we will need to continue monitoring key dimensions of economic, market, and political trends as 2017 comes into view:  financial conditions are tighter; U.S. mortgage rates have spiked nearly 100 bps, cutting nearer-10% off new loan amounts for a given monthly payment; oil prices have risen and the dollar is stronger (important spillovers across the global economy); geopolitical tensions always possible; equity market valuations are elevated in a rising rate environment, and a post-inauguration hangover can’t be ruled out even if repeated new highs are in store. We can reconcile elevated valuations with an expectation that corporate tax reform is likely to boost after-tax profits, and observe that consumer-relevant interest rates do remain below post-recession highs. Monitoring details and likelihood of passing key tax and fiscal reforms will be critical over the first months of the Trump Presidency, the keystone of an upbeat DE outlook.

DE wishes everyone a happy and safe upcoming set of holiday weeks…we will resume publication of the Weekly on December 30^th.

• S.: Fed Chair Yellen appears Monday, speaking about “The State of the Job Market” at a University of Baltimore mid-year commencement, while economic data include the third estimate of Q3 real GDP, November personal income and spending, and November durable goods orders (all Th).
• Eurozone: The coming week has more survey data, most notably the German Ifo data (Mon) which may echo the solid PMI numbers already released for the current month. Also, will any of the coming surveys corroborate signs of rising prices both at the input and output levels that were a key feature of the latest PMIs?
• UK: Final Q3 GDP should highlight the strength in household spending, as should the Services Output data, both sets of numbers out on Friday. Such strength is clearly perturbing, if not puzzling, the BoE. Regardless, a more up-to-date insight in at least the retail side of consumer spending will come from the CBI Trades survey on Tuesday.
• Japan: The BOJ meets just as markets test its yield target of 0% on the 10yr, to the upside. Yield curve control is the new tactic as bond-buying continues apace, but price and quantity can’t both be controlled. A weaker yen and base-effect driven acceleration in inflation should keep the Bank on hold this month.
• Other Central Banks: Central banks in the Czech Republic (Th), Hungary (Tu), Philippines (Th), Thailand (We), and Turkey (Tu) meet. Turkey’s central bank may boost repo and lending rates again this week, helping the lira find a bottom after a significant slide. Political pressure from the government argues for a limited move, and growth sagged in Q3—a delicate balance.

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