The USD rises to a 14-year high, following a more hawkish Fed
The Fed, as expected, increased the target for the Federal funds rate by 25 bps to 0.50% - 0.75%. More importantly, the Fed revised up its median estimate for the Federal funds rate for end-2017 to 1.25% - 1.50%, implying 3 interest rate hikes (compared with 2 hikes three months ago).
The Fed foresee another 3 hikes by end-2018 (to 2.0% - 2.25%). Markets are slightly more benign, expecting a cumulative increase of 125 bps (or 5 hikes) by end-2018.
In the event, Chair Yellen attributed the increase in the Federal funds rate projections to a more favorable outlook for the US labor market. Note that the unemployment rate declined to 4.6% in November (-0.4 pts since September), below the Fed’s NAIRU estimate of 4.8%.
Importantly, Yellen noted that some participants incorporated only minor fiscal policy change assumptions, with GDP projections remaining broadly unchanged (see Economics section). However, the shift in the US policy mix towards higher spending and lower taxes from H2:2017 could trigger a more-aggressive-than-expected normalization rate cycle by the Fed.
Following the Fed meeting, the USD rose sharply by 2.0% against the euro to a 14-year high of $/1.042 and 2.6% against the JPY to ¥/118.2 (a 10-month high). On a trade-weighted basis, the USD strengthened by 0.9% during the past week, reaching its highest level in 14 years.
The S&P500 was broadly flat during the past week, following a post-election rally of +5.6% since November 8th. The prospect of a more aggressive Fed, alongside the rapidly accelerating USD, appears to have restrained sentiment. Japanese equities overperformed, with the Nikkei225 index increasing by +2.1%, to its highest level since December 2015 (19401), due to the sharp depreciation of the Yen (see graph).
Emerging market equities remained under pressure (MSCI EM: -1.8% wow / -2.5% since November 8) due to a stronger USD and higher US rates. Russian equities were the exception (+2.3% wow / +17% since US elections), supported by higher oil prices and the prospect of more favorable relations with the upcoming Trump administration.
US Government bond yields rose sharply due to the surprising upward revision in the FOMC’s expected path for the Federal funds rate. UST 10Yr yields increased by 13 bps wow to 2.59% -- the highest since September 2014 – and, during the week, 2Yr yields reached the highest level since August 2009 (1.28%).
UK Gilts remained broadly flat at the 10Yr tenor (1.44%) as the Bank of England made no policy change (policy rate: 0.25%, QE purchases at £435bn until February 2017) due to resilient economic activity and less inflationary pressures. JGBs yields were also flat at 0.08%, as the Bank of Japan maintained its curve targeting regime on Tuesday (with 10Yr yields at around zero).
In China, the feedback loop between capital outflows and the RMB depreciation continues, with FX reserves down by $69bn to $3.052tn in November, following a decline of $46bn in October (-$150bn since end-July). The RMB has declined by 5.0% against the USD since end-July, to RMB6.97/$.
Depreciating RMB pressures could escalate should: i) the Trump administration be more aggressive in its trade relations with China; ii) the FOMC’s more hawkish outlook for interest rate hikes materialize; and iii) Chinese growth decelerate more aggressively than expected.