Federal Reserve

Expect a more hawkish Fed in the second half of 2017

Analysts expect Trump to be able to agree a tax cut package with Republicans, enabling US growth of 2.75 per cent this year

PUBLISHED : Monday, 30 January, 2017, 6:01pm
UPDATED : Tuesday, 03 July, 2018, 9:47pm

Markets should not underestimate President Donald Trump’s will to implement reflationary fiscal policies and should prepare for a more aggressive Federal Reserve and a stronger US dollar in the second half of 2017, analysts say.

Their advice comes despite the likely damping effect of Trump’s new immigration curbs on risk sentiment. On Friday he signed an executive order temporarily banning citizens from seven Muslim-majority countries from entering the US.

The markets are choppy ahead of the Federal Reserve’s first meeting of 2017, which starts on Tuesday, as expectations of a near-term rate increase fade.

The US dollar tumbled on Monday to its lowest level in nearly two months against its major rivals, with the WSJ dollar index retreating as much as 0.4 per cent to 91.07, after Trump’s immigration order prompted massive protests in the US and unsettled global investors. The Japanese yen, a traditional safe-haven currency, briefly jumped 0.7 per cent to 114.27 per US dollar.

Traders in stock markets also turned jittery, with equities in Asia mostly closing lower.

Japan’s Nikkei 225 ended Monday down 0.5 per cent, while Australia’s S&P/ASX200 and New Zealand’s NZX 50 fell 0.9 per cent and 0.6 per cent respectively.

Meanwhile, expectations over the likelihood of a near-term Fed rate increase have fallen.

The market priced the probability of a March rate increase at 24.4 per cent as of Monday, down from 33 per cent last Wednesday, according to CME Group’s FedWatch tool. The likelihood of a February rate increase stood at just 4 per cent.

But analysts doubt the short-term turbulence will affect the Federal Reserve’s rate-rise path in 2017.

“In our view, the market should not underestimate his [Trump’s] will to implement policies that fulfil his promise to put America first, and boost growth and wealth creation,” said Russel Matthews, a portfolio manager for Macro Strategies at BlueBay Asset Management.

“The flow of news is going to be messy and at times confusing, but the policy agenda will be focused on delivering tax cuts, and reworking trade policy to the advantage of the US.”

We believe that the market needs to price in three to four hikes for 2017 and the same again for 2018
Russel Matthews, BlueBay Asset Management

Although the dollar has underperformed recently due to “over positioning” and some disappointment about a lack of detail surrounding Trump’s reflation bet, analysts believe it will regain ground quickly.

“The primary themes we are investing in remain higher core rates and a stronger US dollar,” said Matthews.

Markets currently price in two rate increases by the Fed this year and two additional rises in 2018.

But Matthews said that is not sufficient.

“We believe that the market needs to price in three to four hikes for 2017 and the same again for 2018,” he said.

“In our opinion, investors seem to be overly focused on the Trump spectacle and may be taking their eye off the more important consideration in the near-term: the Fed. Even without the Trump effect, we have been confident that the underlying strength of the US economy would drive a more aggressive Fed hiking cycle in 2017.”

Michael Pearce, global economist for London-based Capital Economics, expected the pace of the Fed’s rate increases to pick up in the second half, although it may await some policy signals from Trump in the short run.

“Plans for a fiscal stimulus, health care reform, and changes in trade policy may all have significant implications for inflation and thus monetary policy,” he said. “The Fed will therefore be content to leave policy on hold for the next few months while awaiting more clarity.”

There is still a huge amount of uncertainty about what policies the new administration will pursue in the first half of the year, he added.

However, his best guess was that Trump will be able to agree a package of tax cuts with Republicans in Congress “fairly quickly”.

Therefore, US economic growth will accelerate to around 2.75 per cent in 2017, pushing up wage growth and inflation.

“Under these circumstances, we would expect the Fed to accelerate the pace of policy tightening in the second half of the year, raising rates four times in 2017 followed by another 100 basis points of hikes in 2018,” Pearce said.

The Federal Reserve raised interest rates in December by 25 basis points, the first tightening move in a year. The current Fed funds rate is in a range of 50 to 75 basis points.