Fed turns more hawkish reinforcing USD strength - MUFG

The US dollar has remained at stronger levels in the Asian trading session after strengthening sharply following yesterday’s FOMC meeting notes Lee Hardman, Currency Analyst at MUFG.

Key Quotes

“The Fed resumed monetary tightening as expected by lifting the target range for the Fed funds rate by 0.25 percentage point. The main surprise was that the Fed adopted a more hawkish outlook for monetary policy signalling that it now plans to raise rates by a further three times in 2017 up from the two hikes signalled back in September.”

“It has prompted a sharp jump higher in US short rates which have adjusted to discount a higher probability of between two and three rate hikes next year offering more support for the US dollar. While we had been expecting the Fed to speed up the pace of rate hikes next year, we were surprised that the Fed adopted a more hawkish tone at the current juncture having expected it to wait until there was greater clarity over the outlook for fiscal policy under President elect Donald Trump.”

“Fed Chair Yellen stated that the updated outlook for Fed policy was a “reflection of the confidence we have in the progress the economy has made and our judgement that that progress will continue. The economy has proven remarkably resilient”. The accompanying policy statement highlighted that the Fed has been particularly reassured by recent developments in market-based measures of inflation compensation which have moved up “considerably”.”

“However, Fed Chair Yellen was still keen to downplay the “modest adjustment” that some FOMC members had made to their forecasts for the Fed funds rate reiterating that “we continue to expect the evolution of the economy will warrant only gradual rate increases”. Her more dovish rhetoric has had limited initial impact.”

“The updated Fed forecasts do not appear to have factored much of an impact yet from the likelihood of looser fiscal policy under President elect Donald Trump. The Fed’s economic growth, inflation and unemployment rate forecasts were all left largely unchanged although some FOMC members may have factored in to some extent the likelihood of looser fiscal policy into their forecasts for more rate hikes next year.”

“If President elect Donald Trump follows through with looser fiscal policy it will likely prompt the Fed to lift their forecasts for growth and inflation which could justify an even faster pace of rate hikes in the coming years than the six currently planned during 2017 and 2018. In contrast, we estimate that the market is currently discounting between four and five rate hikes by the end of 2018.”

“After waiting a year to follow up the first rate hike, the next rate hike is likely to be delivered much sooner. It could even come as early as at the March meeting although we believe it is more likely to be delivered in Q2. In these circumstances, the US dollar should continue to strengthen in the near-term rising to new cycle highs although the hurdle for further upside is rising as well given the amount of tightening already priced in is becoming more significant.”