- Steeper policy rate path is becoming more likely.
- Recent market turbulences no reason to be concerned.
- Regulatory framework is set to be modified somewhat.
- Further stronger U.S. yield growth is unlikely but dollar will benefit from stronger hiking pace.
Jerome Powell made his first significant appearance as the new chairman of the Fed in testimony before the U.S. Congress this week. Market reaction to Powell's remarks was rather strong with the U.S. equities facing another round of sell-off while dollar gained as investors ramp up the odds of a faster pace of rate increases this year. Meanwhile, Powell's optimistic assessment pushed US 10-year yield back above 2.9%.
The minutes of the Fed's meeting in January hinted that the central bank will raise interest rates again in March and that there will be four steps in total in 2018 (versus three expected in December 2017). With regard to the latter, Powell stated: "I would say that my personal outlook for the economy has strengthened since December. And again, each member of the FOMC is going to be writing down a new set of projections and a new estimate of appropriate monetary policy as we go into the March meeting, which begins three weeks from today, and so I wouldn't want to prejudge that new set of projections, but we'll be taking into account everything that happened since December."
Indeed, the FOMC last submitted forecasts in December, and since then, wages increased at the fastest pace since 2008 and labor market conditions improved further.
Chairman Powell took the recent volatility in financial markets as a transitory and did not express excessive concern on the topic. In the written part of his testimony, Powell stated: "At the current point, the FOMC does not consider that recent market developments will have stronger impact on the economic activity outlook, labor market or inflation". Furthermore, in a response to a question about what keeps him awake at night, Powell replied that they are having problems associated with strong growth and that is a good problem to have.
Testimony was heavily focused on the regulatory agenda. In detail, Powell stated that the Fed is considering tailoring certain regulations to reduce excess burden while protecting the safety and the soundness of the U.S. financial system. Also, Powell considers that the Volcker rule should be re-examined given his potentially unfavorable impact on fixed-income market liquidity. However, Powell defended many of the post-crisis reforms which include higher capital and liquidity requirements and stress testing. With that being said, Powell's remarks on the regulatory framework suggest that he is willing to set loose the provisions that had gone too far but it does not seem that supports general remake of the regulatory framework. De-regulation of any kind usually goes hand in hand with better performance of economy in the near term.
While publishing its latest projections in December, FOMC upgraded 2018 growth expectations by 0.4pp to 2.5%. However, the expected hiking rate pace was left unchanged at three rate hikes this year. The recently passed budget agreement came after FOMC January meeting, and I believe that FOMC will further upgrade its growth expectations at the meeting in March to reflect the effects of higher budget caps for public sector spending. The latter combined with Powell's rather optimistic assessment on the general economic conditions and inflationary pressures strengthening points to a risk of a steeper policy rate path in this year and next.
We have recently witnessed that the correlation between the US yields and the USD index has broken (see chart below). I believe that this is due to a fact that the larger part of the US yields increase in the recent period was due to higher risk premium in the aftermath of increased budget caps and the fact that budget deficit is heading to surpass 5% of GDP this year. Moreover, according to the US Joint Committee on taxation, total deficit is set to surpass 7% of GDP by the end of 2027 if the government proceeds with the spending from Bipartisan budget act of 2018.
Chart 1: USD index and UST 10Y yield
However, recent budget deal extended debt ceiling until March 2019. Boost from imposed tax cuts and higher spending will begin to fade in 2019 and fiscal policy could become a drag on the economy by 2020 if Congress fails to agree on a new deal to raise spending levels and the previous caps were re-imposed.
US dollar managed to benefit from increased hiking pace expectations in the aftermath of Powell's speech and the EUR/USD exchange rate has fallen below 1.22 mark for the first time since mid-January. Therefore, I believe that dollar will profit from stronger hiking pace through the course of this year in spite of worries about US growing budget deficit.
Chart 2: EUR/USD movements
Secondly, further growth upgrades will lower market concerns about U.S. growing debt burden as economy with higher growth rates can deal more easily with higher debt levels. This will lower country risk premium somewhat. Therefore, I do not expect stronger U.S. yield rise in the rest of the year as stronger hiking pace will just offset the decline in risk premium.
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