As expected, the minutes from the FOMC January meeting revealed that the Fed is getting closer to hiking rates. The minutes were nevertheless perceived as being relatively hawkish given that the market expectation of a rate hike in March was just 18% prior to the release of the minutes. Probabilities rose to 22% after their publication; a marginal increase, far from strongly signalling a rate hike at the next meeting of March 14-15.
This is probably a good assessment of the probabilities of a rate hike in three weeks. There are some economic data of significance coming out in the meantime that could change the FOMC’s assessment of the situation. However, there are several structural elements to justify the belief that the Fed will remain on the sidelines, at least until later this spring:
- Inflation is still low and the favorite inflation measure of the Fed (the Personal Consumption Expenditure Price Index or PCE) was still stuck at 1.6% in January, below the Fed’s 2% target.
- The uncertainty concerning the trade policies of President Donald Trump is still quite high.
- The fiscal plan of the Republican administration which could add some significant stimulus and give way to rising inflation is not yet known and Treasury Secretary Mnuchin just hinted that the tax reforms won’t be in place before the end of the summer. This is leading us to believe that, unless tax cuts are agreed upon before the tax reforms are enacted, the fiscal stimulus won’t have much of an impact on growth and inflation before 2018.
- In the meantime, the USD is appreciating against most currencies, weakening the American trade balance.
- With rising long-term interest rates and a stronger dollar, financial conditions are tightening and lowering the growth outlook for both U.S. investment and consumption.
- Finally, global geopolitical uncertainty is rising:
• Europe is showing better growth and inflation numbers than a couple of months ago but France, Germany and the Netherlands will soon be holding elections and are seeing the rise of populist movements that could shatter the European Union.
• The Greek debt crisis is coming back to the surface at a time when elections are forcing European politicians to show strength rather than adopting a conciliatory tone towards renegotiating Greece’s debt.
• Brexit will be playing out full blast after the UK finally invokes article 50 of the Lisbon Treaty at the end of March.
• Italy’s Renzi just resigned, deepening the political vacuum caused by his lost in the recent referendum on constitutional reforms.
• Russia’s meddling in the U.S. presidential election and its intervention in Ukraine are still rattling Washington.
• ISIS is still on the loose and President Trump has yet to decide how he wants to deal with the problem.
• China’s trade surplus with the U.S., Mexico’s wall on the American southern border, the deportation of illegal immigrants from the U.S. and Trump’s ban on foreigners from seven countries are all unfolding files which are expected to add more uncertainty to the growth and inflation outlook in the U.S. over the coming months.
This being said, it is appropriate in our view to anticipate a few rate hikes from the Fed in 2017, making the timing of the first one relatively irrelevant. As a result, we still expect that long term U.S. interest rates will keep increasing in the coming months, putting more pressure on long term rates elsewhere (Europe, Canada, and Japan). We also of the opinion that the USD will continue appreciating with respect to most currencies. However, we believe that because oil prices will keep going up in 2017, the Canadian dollar is the only major currency which will outperform the USD this year.