The US Federal Open Market Committee (FOMC) raised rates, as was almost universally expected, and also just barely upped its forecast for this year to four rate hikes from three as one person changed their end-year forecast to 2.375% from 2.125%, which shifted the median up a notch. The Committee still sees three rate hikes in 2019 but now only one in 2020. The rate hiking cycle is forecast to end at the same level but just get there a bit faster. The longer-term forecast was also unchanged.
The change came as the members forecast that growth this year would be stronger, unemployment would be lower and inflation would be higher than they had thought in March. Note that core PCE inflation is expected to be slightly above target for 2019 and 2020, in line with the statement’s stress on the “symmetric” inflation target (i.e., allowing for short-term overruns as well as periods of below-target inflation).
The statement accompanying the decision reflected this more optimistic outlook. As I expected, they dropped the forward guidance about rates being likely to remain low “for some time.” In its place they said that
The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term.
This is quite a significant change. Previously, they had said that “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate…” In other words, they had been saying that future rate hikes were dependent on the economy; now they’re saying that future rate hikes are coming, period. It shows much more conviction about the hiking cycle.
Still, there’s no sense that they are behind the curve or overly concerned about inflation. As Fed Chair Powell said that the press conference, “If we thought inflation would take off, we would be showing higher rates.” On the contrary, while the pace of rate hikes this year may accelerate, all told they are still targeting the same end-point. Powell said the Fed was continuing to discuss the metrics it will look at to determine when it has reached a “neutral rate” for the fed funds, that is, a level that is neither boosting nor slowing the economy. “We know that we’re getting closer to that neutral level,” he said.
The market is pricing in about 68 bps left to hike – a little bit less than three more hikes, vs the five that the FOMC is forecasting.
The press leaks proved correct; Powell will start holding a press conference after every FOMC meeting, starting in January. This brings the Fed into line with ECB and BoJ practice.
Given the hawkish tone, why did the dollar then decline? Probably because the market sees the end of the hiking cycle coming, whereas elsewhere – notably the Eurozone – it’s just beginning (see below). Also although US bond yields initially took off after the announcement, they closed mixed: higher (2yr) unchanged (5yr) to lower (10yr). It looks to me like a typical “buy the rumor, sell the fact” reaction. Or perhaps with the Fed out of the way, the market is once again focusing on trade: the US administration Friday will release a final list of targets for tariffs on trade with China, and Trump said he’ll confront China “very strongly” over trade in coming weeks. Such confrontation seems more likely now that Trump and Kim are best buddies, because Trump no longer needs China to help him with North Korea.
AUD was weaker on disappointing employment data. Although the unemployment rate unexpectedly fell, this was more due to a fall in the participation rate than an increase in employment, which missed estimates. Furthermore the mix of employment was disappointing, with a fall in full-time jobs more than offset by a rise in part-time jobs. The currency was subsequently hit again by the weak China data: retail sales, industrial production and fixed asset investment all missed estimated. I expect that AUD is likely to remain under pressure as a currency that’s unlikely to see a rate hike any time soon.
Today’s main event: ECB meeting
The ECB will be grappling with the question of what to do with their asset purchase program. The program is scheduled to run “until the end of September 2018, or beyond, if necessary,” according to the ECB’s statement. That means they either have to announce what they intend to do at this meeting or the one in July, as there isn’t an August meeting.
In fact, ECB Chief Economist Peter Praet specifically said last week that “the Governing Council will have to assess (at the June meeting) whether progress so far has been sufficient to warrant a gradual unwinding of our net purchases.” He reiterated the ECB’s three criteria for changing rates, namely getting inflation back to the target level, getting it there on a sustained basis, and having it stay there without support from the ECB. He implied that they’ve met the first two criteria and will just have to evaluate the third. I expect that they’ll determine that they’ve met all three criteria and that they’ll decide to end the quantitative easing (QE) program, probably by December. That’s pretty well discounted by the market by now I think, but I think it still it should be positive for the euro.
There is a possibility that they “assess” the progress but don’t make any decision. Given the turmoil in Italy and the problems facing world trade, they might well decide there’s no harm in keeping the market in suspense for an extra month. On the other hand, they might not want the Italian government to think that the QE bond purchases will bail out the country and so they could take an earlier decision just to avoid this moral hazard. In any event, the recent plunge in Italian yields makes the country’s needs less important a factor. Regardless, they could decide that even if the first two criteria are met, they want another month to make sure they’re met sustainably.
Like with the FOMC yesterday, a lot depends on the new economic forecasts. The staff growth projections are likely to be revised down. If inflation is revised down as well, they may have a hard time deciding to end the QE program so that seems unlikely to me. Even though headline inflation hasn’t met their March forecast, they could use higher oil prices and the weaker EUR to justify revising inflation higher even while they revise GDP growth lower.
Market impact: I think a clear decision to end the asset purchase program in December would be positive for the euro. No matter how well telegraphed the move is, there must be some doubt about it. At the same time, if the decision is put off another month, that’s likely to be negative for the euro, because there must be some people who are expecting it at this meeting. All told, I expect much greater volatility in EUR than usual around this ECB meeting.
The day starts with UK retail sales. The mom figure is expected to be down sharply from the previous month, but at least it’s up, as warm weather and the Royal Wedding probably boosted spending a little. That should boost the yoy rate of growth to the highest level since last June and perhaps calm fears that the Q1 slowdown might be continuing. GBP-positive.
The US retail sales figures are expected to show a modest bounce in sales, following April’s relatively sluggish growth. Growth in May was depressed by falling sales of autos. Nonetheless, the figure is expected to be slightly above trend as the strength in the labor market and high levels of consumer confidence support consumption. USD-positive (Note: I focus on the “advance” measure of sales, the headline number, because that is what has the highest correlation with the subsequent movement in the FX market.)
US import prices are expected to rise fairly sharply. Especially on a yoy basis, the rate has been between 3.2% yoy and 3.5% yoy since last November, but is expected to break out to +3.9% yoy. That could add to the idea that US inflation is on a sustainable upward trend and would therefore be positive for the dollar. Note that the rise in import prices is not due solely to higher petroleum prices. Excluding petroleum, the index is forecast to be up 0.2% mom, which would translate into a 1.9% yoy rate of increase, an acceleration from +1.6% yoy in the previous month.
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