Sobre la FED

AXA IM - Viernes, 10 de Marzo

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US Federal Reserve outlook: March & Three The risks around March’s meeting and the likely market implications Robust momentum appears to have persuaded the Fed to tighten monetary policy in next week’s FOMC meeting. We update our Fed Funds Target outlook and consider risks associated with the upcoming meeting. We also detail our revised outlook for US Treasury yields, FX and FX hedging costs.

With March expectations so solid is there any room left for surprise?

The combination of improved economic sentiment and robust growth in domestic demand led the US Federal Reserve (Fed) to signal that it will likely continue to tighten monetary policy in March, slightly earlier than our June forecast. Last week, New York Fed President William Dudley stated the case for an interest rate hike had become “more compelling”. In addition,

Fed Chair Janet Yellen said that a March hike “would likely be appropriate”. We now expect the Fed to raise the Federal Funds Rate (FFR) by 0.25% to 0.75-1.00% on 15 March and believe that the Federal Open Market Committee (FOMC) will increase rates three times this year, pencilling in increases in June and December, although we acknowledge that such a path would be data dependant. We also consider a risk that the Fed moves even more aggressively, hiking each quarter this year. However, this remains an alternative scenario, rather than a central view as we expect some retracement in sentiment, an economic headwind from three hikes in 2017 and communication on balance sheet policy to reduce the need for a faster pace. This view has become consensus, with overnight index swap(OIS) markets now implying a 100% chance of a Fed rate hike in March (from 34% at the start of last week). For the rest of the year the market is still pricing in less than two hikes (Exhibit 1).

Exhibit 1

Market remains more dovish

Implied Fed funds' target rate

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

%

FOMC dots median
OIS - As of meeting date AXA IM projections

With expectations having moved so decisively over the past week, we consider little risk of disappointment for the immediate rate view. However, a range of attendant risks could impact how markets react to such a rise. The biggest is associated with any changes to the FOMC’s Summary Economic Projections (updated for the first time since December this month). The broader market view is now anchored around the Fed’s median expectation of three hikes in 2017. But this expectation reflects Fed participants’ views in December. We see a risk that the Fed upgrades its GDP projections next week, reflecting a revival in household and business sentiment. This may result in participants increasing their rate outlooks further. With markets now realigning their expectations to the Fed outlook – different to the behaviour of the past couple of years – such changes in the Fed outlook could quickly feed into market expectations.

Against the risks of rising expectations, the Fed is likely to manage expectations over future policy actions. We think markets will consider a more consistent Fed hiking schedule, perhaps assuming one quarter (% rate hike) per (calendar) quarter. Fed Chair Yellen is likely to be wary of markets adopting such a view. She should stress that future moves will remain data dependant and that the Fed expects future policy normalisation to remain gradual. This could lead some to interpret a “dovish hike”, muting the expected reaction.

There is also a risk that the Fed provides additional guidance on managing its balance sheet at this meeting. Various Fed Presidents have expressed differing views of when they see the Fed fulfilling its commitment to maintain the reinvestment of maturing quantitative easing (QE) assets, namely when rate normalisation is “well under way”. Philadelphia Fed President Patrick Harker suggested when the FFR reached 1%; New York Fed President Dudley suggested 1.5%. With our year-end expectation for the FFR now at 1.25-1.50%, these are becoming proximate triggers. The need for additional guidance from the Fed is growing. Yet Fed Chair Yellen has not shown any signs of any urgency. In her semi-annual address to Congress, she offered no update on balance sheet policy, and only responded under questioning that further guidance would be made available over the coming months. This timeline suggests such guidance around the time of the June Fed meeting. However, there is a risk that we get some update next week.

2017

2018
Projections year end

Longer term

Source: Bloomberg and AXA IM Research

2019

Finally, beyond the Fed’s cyclical assessments there is also a risk that it changes its structural view. Fed participants lowered their view of the long-term neutral rate over the first half of 2016, from 3.5% in December 2015 to 3.0% in June 2016. There is a risk that as medium term growth forecasts begin to rise, the Fed may become more optimistic on the outlook for longer-term growth and the neutral rate. Indeed the FOMC median view dipped below 3% to 2.9% in September but then rose again to 3% in the latest forecasts. There is a risk that this assessment will rise over the coming quarters and might even be included in next week’s forecasts.

What could be the impact on longer-term yields?

A change in key interest rates generally brings about a change in the same direction for long-term bond yields, with the sensitivity of 10-year yields to overnight rates estimated to average 30%. During periods of policy tightening, this relationship tends to grow even closer. Based on this and given our outlook for three rate hikes this year (with the risk of four), the 10-year yield could reach 2.9% by the year-end, compared to our previous forecast of 2.75%.

Consequently, we think the bias on long-term yields remains to the upside. Technical factors suggest the natural decline in the average maturity of the Fed’s portfolio in 2017 could increase 10-year yields by roughly 15 basis points (bps) according to Fed estimates. Such passive Fed tightening could exacerbate pressure on the term premium equivalent to a 50bp rate hike1. Because QE has put considerable pressure on term premia, it will be even more important to follow the Fed debate on balance sheet evolution. Moreover, we think that more upside pressure on the term premia could arrive if the terminal FFR estimate is revised higher. According to our yield model, a 50bp increase in the long-term FFR would drive the 10- year yield up by more than 20bps.

Impact for EURUSD and hedging cost

The USD has rebounded after the Fed officially flagged a March hike: it rose against a number of currencies, especially GBP, JPY and CAD, but less so against the euro which has stayed strong recently. As FX markets are not fully pricing the three Fed moves for 2017, we think there is some room for the USD to rally further in the short term. We use our EUR/USD model to measure the pass-through of higher interest rates to the exchange rate over the medium term. We expect three-hikes in 2017 to raise US short- term rates (2Y) to around 1.85% by the beginning of next year versus our previous forecast of 1.60%. Our model shows that the resulting interest rate differential tightening versus euro-area interest rates would trigger a EUR/USD depreciation of around three figures until the beginning of 2018.

In Europe, markets could become more concerned
about political risk as we get closer to the first round of
the French election, which in turn could lead to more
euro weakness in the coming months. However, we
also see some euro upside risks once the French elections are behind us. As we anticipated, the rise in political uncertainty in Europe since October, explains
about two figures in the decline in EUR/USD, but there 3% is scope for a similar bounce back if political uncertainty eases. Moreover, market attention will quickly shift to European Central Bank tapering, providing renewed support to the euro. Overall, even though risks are tilted toward more EUR depreciation

Exhibit 2

Cost of hedging to increase up to 3.25% in 4 years

Evolution of 3M FX Fwd USD hedging costs for a EUR investor

4%

2%

1%

0% year end, with a target of 1.05. -1%

in the near term, we remain neutral on EUR/USD by

Market expectation

At the moment, the market is not factoring in an
acceleration of the pace of Fed rate hikes. If it did, the
cost of hedging USD investments back to EUR with
forex forwards would probably rise significantly.
Considering three month forwards (Exhibit 2), the
annualized cost of rolling short term forex forwards
over a three- to four-year period would increase from around 1,7% annualized currently to more than 3,25%. This advocates for lengthening the duration of hedges beyond four years, while market expectations are still lower. This can typically be achieved by hedging USD duration.

1 Janet Yellen’s speech on “The Economic Outlook and the Conduct of Monetary Policy”, Board of Governors of the Federal Reserve System, 19 January 2017

Impact of AXA-IM scenario 2010 2012 2014 2016 2018 2020 2022 2024 2026

-2%

Source Bloomberg and AXA IM Research 

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