It is finally time for the Fed to make the first 2016 rate hike. Having postponed it many times during the year, the FOMC will almost surely increase rates by 25bp - from 0.25/0.5% to 0.5/0.75% - at the end of Wednesday, 14 December monetary policy meeting. It would be the first rate hike since December '15.
All economic data published over the last few weeks confirm that the US economy is in a positive trend, with further improvement at the tail end of the year that seems very likely. The solid November labor market report was the most positive indication for the Fed: non-farm payrolls rose by 178k and the unemployment rate decline to 4.6%. The CPI edged up from 1.5% y/y to 1.6% y/y in October. The CPI was at 0.2% y/y in October 2015.
The latest leading indicators also signaled that economic activity could further improve at the tail end of the year. For example, the ISM manufacturing index rose to 53.2 in November, the highest value of the year. According to the ISM institute estimates, the figure "corresponds to a 3.2% increase in real GDP annually".
The focus of next week monetary policy meeting will be on the new projections on economic growth and inflation. In September, the Fed projected real GDP to rise 2.1% in 2017 and 1.9% in 2018 and inflation (PCE deflator) by 1.8% in 2017 and 1.9% in 2018. We do not expect the Fed to make significant changes to these estimates as the latest data were in line with the base scenario of a gradual improvement of the economy.
We do not see the election of Donald Trump as president of the United States to have an impact on the Fed estimates. During the electoral campaign, Trump said he would implement a plan of public investments worth USD1trn and adopt protectionist measures, which could increase inflationary pressures. However, we think that the Fed should consider this scenario only when these measures will be implemented.
Therefore, the Fed should continue to estimate three more rate hikes in 2017, with the Fed Fund rate at 1.25/1.5% at 2017-end.
The recent upward trend of the US Dollar should strengthen the view that the Fed will continue raising rates at slow pace in the months ahead. The Dollar index rose to the highest since January 2003 and the Euro/US Dollar exchange rate remains well below the average level of 1.1 before the Trump election. The strength of the USD has already had a restrictive effect on monetary conditions. In this scenario there is no reason for the Fed to accelerate the tightening of monetary policy. For this reason, we think investors should continue to estimate a slower tightening of monetary policy compared to Fed projections. Indeed, the Fed fund futures discount with a 30% possibility two rate hikes in 2017.
In our view as long as the Fed will be chaired by Janet Yellen there will not be an acceleration of the tightening of monetary policy. Only the appointment of a new Fed Chairman in 2018 - when Yellen mandate will come to end - could mark the beginning of more tight monetary policy. This is especially true if the new president will be an advocate of the use of monetary policy rule. For example, the classic Taylor rule now provides that the Fed Fund rates should be at 4%.
The tightening of monetary policy and the improvement of economic activity could increase upward pressure on government bond yields, especially on long-term government bonds (NYSEARCA: AGG). Despite the increase from 1.4% in July to 2.4% over the last week, the 10-year government bond yield remains at historically low levels. We think that an increase to 3% will not have any major impact on economic impact. Only a marked acceleration of both inflation and economic growth could push the 10-year yields above the 3% threshold as it will force the Fed to revise its plan for gradual rise of interest rates.
In our view, the recent steepening of the yield curve - the spread between the 3-month T-Bill yield and T-bonds 10 years yield is 2% - should continue to support the equity market (NYSEARCA: SPY) as it anticipates an improving of economic activity in the coming months. A declining spread, on the contrary, would signal a slowing economy and increase the doubts about the sustainability of the equity market rally.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.