What the Fed’s changing dot plots mean
The Fed’s decision to hike interest rate also means a long winter for the bond market, although no doubt there’ll be some profit-taking on the way
Mumbai: If emerging markets thought that the election of Donald Trump as the next President was possibly the biggest party pooper event of 2016, the US central bank is now giving it strong competition.
The Federal Open Market Committee (FOMC) voted unanimously to raise the Fed target rate by 25 basis points to 0.5-0.75%—a move regarded as virtually certain by markets.
But what rocked the market’s boat is the Federal Reserve now predicting it would step on the gas for future rate hikes. The dot plots of the Fed have changed and now show that there may be not two but three rate increases next year.
The chart shows the change in the market expectations of where the Fed funds target rate will be by November 2017. Note that the probability of it being more than 1.25% is at 24.5%.
By December 2017, that probability rises to 46.2%, which means that the market is pricing in a 46.2% probability of more than two rate hikes by the Fed by December 2017.
The fact that the Fed’s own targets for growth and inflation haven’t moved suggests that the accelerated pace of rate hikes foreseen is because of Trump’s economic proposals. That ties in nicely with the sudden rise in US bond yields, on expectations of a push to infrastructure and fiscal loosening. Indeed, the rise in bond yields in the US is entirely on account of fiscal stimulus expectations and doesn’t owe much to monetary tightening.
Of course, this is where future Fed actions have their shade of unpredictability. The key feature of Trump’s fiscal canvas is that it is unpredictable. This seems to have fittingly rubbed off the Fed as well. Global markets didn’t expect the Fed to materially change its pace of future rate hikes but the Fed has. So will the Fed become even more unpredictable, goaded by a changing fiscal sphere? It would be wise to recall that the Fed’s moves in 2016 weren’t exactly predictable either. Much depends on what Trump finally delivers as opposed to sky-high expectations.
For emerging markets, there is indeed another year of uncertainty in the waiting. Amidst all this, what is certain is the dollar’s rise. A strengthening dollar would mean emerging market currencies would weaken faster, central bank intervention would accelerate and dollars would flow back to the US.
It also means a long winter for the bond market, although no doubt there’ll be some profit-taking on the way. US yields have already begun their steep climb and with dollar assets reclaiming their pre-crisis returns, the lure of emerging markets will lessen.
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