S&P 500, Dollar And Government Bond Yields Outlook After The Fed

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Summary

We think that the rise of the US dollar and the government bond yield makes it unlikely that the Fed will raise rates 3 times in 2017.

The recent strength of the US dollar could have a negative impact on economic growth. In our view, the upside potential of the US dollar is limited.

Government bond yield could continue to be penalized over the next few weeks by the expectations that President Trump could implement a strong expansionary fiscal policy.

In our view, the steepening of the yield curve should continue to have a positive impact on the equity market.

We see two main sources of risks for the equity market: a decline of long-term government bond yield and a jump in inflation, forcing the Fed to hike rates aggressively.

In line with market expectations, the FOMC decided to raise rates by 25 basis points at the end of Wednesday, December 14, monetary policy meeting. However, contrary to our view, the Fed raised its estimate for the number of rate hikes in 2017 from 2 to 3, albeit maintaining both GDP and inflation projections for the next 2 years almost unchanged. Fed members estimated GDP will grow by 2.1% in 2017 and 2% in 2018 and inflation by 1.9% and 2%, respectively.

Despite being caused only by higher projections of some Fed's members, the impact of the upward revision of Fed Fund rate projections on the markets has been remarkable, especially when it comes to the US dollar and government bond yields.

For example, the Dollar Index, the benchmark of the US dollar against major international currencies, rose to the highest since 2003. The EUR/USD fell to 1.04 (NYSEARCA: FXE), again a value not touched since 2003. The two-year government bond yield jumped to 1.26%, from the minimum of 0.6% in July, and the ten-year government bond yield from 1.4% in July to 2.57%.

However, we think that the rise of the US dollar and of the government bond yield makes it unlikely that the Fed will raise rates 3 times in 2017. Indeed, these are already having a restrictive effect on monetary conditions, as highlighted by our monetary conditions index, which is well above long-term average.

Only a strong increase of inflationary pressures or the implementation of highly expansionary fiscal policies by the Trump administration could force the Fed to raise rate to 1.4% at 2017-end. In our view, the Fed's estimate for a 2.1% growth in 2017 is in line with 2 rate hikes in the coming year.

Moreover, the recent strength of the US dollar could have a negative impact on economic growth. According to an OECD forecasting model, a 10% increase of the US dollar reduces GDP growth by 0.2% after one year and by a further 0.7% in the second year. In this scenario, the Fed could decide to raise interest rates less than projected to diminish upward pressure on the currency.

In our view, the upside potential of the US dollar is limited. First, because the spread between the US and German 2-year government bond yields is already at historical high. Only a further widening of the spread could justify a strengthening of the US dollar.

Second, because the US dollar is more than 20% overvalued against the EUR according to OECD PPP, a value that was hardly overcome in the past.

Government bond yield (NYSEARCA: AGG) could continue to be penalized over the next few weeks by the expectations that President Trump could implement a strong expansionary fiscal policy. We think that a return of the ten-year government bond yield to 3% in H1 '17, the value of early 2014, is a clear possibility. However, an increase above that level requires a strong increase of both GDP growth and inflation, which will force the Fed to raise rates aggressively.

The equity market (NYSEARCA: SPY) had a mixed reaction to the Fed's monetary policy decision but closed the week almost unchanged. In our view, the steepening of the yield curve, with the spread between the 3-month T-Bills and the 10 years T-Bonds at 1.6%, should continue to have a positive impact on the equity market. Indeed, a steep yield curve is a positive leading indicator for a sustained growth of profits in the next 3 years, even if market expectations for an increase of 11.5% in 2017 seem too optimistic. The financial sector should be the biggest beneficiary of the steep yield curve and could offset the negative impact of the strong US dollar on multinationals' foreign profits.

In this scenario, we see two main sources of risks for the equity market. First, a decline of long-term government bond yield as it would be the sign of lower than expected economic growth. Second, a jump of inflation that would force the Fed to tighten monetary policy, strengthening the US dollar.

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.

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