The Fed meeting re-assured investors with the signal that although interest rates will head higher, they will do so at a slow pace. Indeed, the projections of the FOMC imply a much slower rate hike cycle than seen historically. This partly reflects the surge of the dollar, which is doing some of the Fed’s job for it. We have made some changes to our forecasts. We now expect the Fed to start raising rates in September rather than June. In addition, our EUR/USD forecast has been revised lower, while our eurozone GDP forecast has been revised higher.
We now expect the first interest rate increase in September rather than June.
Nick Kounis Head of Macro Research
Patience is history
The big event of the last week was the FOMC meeting. There was already speculation beforehand that the Committee would drop the word ‘patience’ from its statement and this is exactly what it did. This word had been used to communicate that the Fed would unlikely raise interest rates any time soon. So this means that the countdown for a Fed rate hike has now begun. The Fed explicitly ruled out an April move, but opened the door for actions in the months ahead, based on how the economic data evolved.
Read my dots
However, the so-called ‘dots’ stole the show. This is the chart that shows FOMC members’ expectations for the appropriate policy rate going forward. Each dot show the expectation of an individual FOMC member. There is quite a dispersion of opinions, but markets focus on the midpoint. The dots for 2015-2016 generally shifted downwards. This signalled a slower pace of interest rate increases. Indeed, the projections of the FOMC imply a much slower rate hike cycle than seen historically (see chart). Investors cheered of course, with most asset classes rallying on the announcements, with the exception of the US dollar.
The dollar is a key part of the story
The strength of the dollar over recent months seems to be an important factor explaining the more cautious approach of the Fed. Chair Janet Yellen noted in the press conference that the dollar’s rise had weighed on exports and dampened inflation. In that sense, the dollar is doing some of the Fed’s ‘job’ for it, as it has already tightened financial conditions. Furthermore, it seems likely that the dollar will rise further against the euro and other currencies given that other central banks are engaged in various degrees of monetary easing. In addition, inflation is subdued. So there is no need for the Fed to be aggressive.
Rate hikes still seen this year, but later
Following the FOMC meeting, recent softer economic data and the outlook for ongoing dollar strength, we have made some changes to our scenario for the Fed. We now expect the first interest rate increase in September rather than June. We then expect it to slowly increase interest rates at a pace of once every other meeting through in to the first half of 2016. After that it may well speed up a little to once every meeting. Overall, that leaves our forecast for the end of this year at 0.75% (from 1%) and for the end of 2016 at 2.25% (previously 3%).
US outlook positive
The outlook for the US economy is still upbeat. This was something that Chair Yellen went out of her way to point out. Employment is expanding strongly, and unemployment is on a strong downward trend. Given the windfall for consumers from the fall in oil prices, prospects for consumer demand are very encouraging. Some of this strength will be offset by weaker exports and manufacturing. As mentioned before, the strength of the dollar will be a drag, but weaker energy sector investment, the other side of falling oil prices, will also be a negative factor.
EUR/USD set to fall further
Despite the rise this week after the Fed meeting, the EUR/USD has fallen more quickly than we expected over recent weeks. It is now not too far from our end 2015 forecast of 1.05. In addition, there good reasons to think that it will fall further. Even the more moderate profile of US Fed rate increases is not fully expected by financial markets. At the same time, ongoing asset purchases by the ECB as part of its QE programme will continue to weigh on eurozone bond yields and the euro. Given the monetary divergence, we now see EUR/USD falling to 0.95 by the end of this year.
Upward revision to eurozone economic growth
Being relatively optimistic about the eurozone economic outlook used to be something that would generate strange looks from people. Okay, maybe it still does. However, that has been our position for some time, and we have actually become more positive. We have revised up our forecast for GDP growth for this year to 1.8% from 1.6% previously. This reflects the ongoing fall in the euro, which will have a big effect on net exports (see chart). Our 2016 projection is slightly higher at 2.3% (was 2.2%). The fall in the euro will also likely start to push import prices in coming months (see next chart), feeding through to core inflation with a lag next year.
Some (very early) thoughts for 2016
Looking ahead is obviously uncertain, and looking more than a year ahead is especially precarious. However, it is still worth sharing some early ideas. The ECB has signalled it intends to continue its asset purchases until September 2016. It could go on beyond that if by then it judges that inflation will not return to close to 2% in the medium term. However, by then that ‘medium term’ will be 2017-2018. If the economy and inflation gain some momentum as we expect, it will probably be satisfied by then that inflation is on track to hit 2% over that time frame. So we think it is likely that the ECB will probably end its programme by then or at least start a gradual tapering of its asset purchases.
ECB tapering and exit the big theme next year
Given that markets are forward looking and given the big impact ECB QE is having on market prices – not least core bonds - it therefore seems likely that tapering and exit will be big themes for investors from the turn of the year onwards. Against this background, we expect core bond yields and the euro to rise as investors start to price in the exit. Although the Fed will likely still be raising rates, its cycle will likely be already largely digested by markets by then. We therefore expect the EUR/USD to bounce back to 1.10 next year.