The Federal Reserve’s decision on Wednesday to raise interest rates by 25 basis points was widely anticipated, but markets were surprised by the hawkishness in the policy statement and Chair Janet Yellen’s press conference.
Even though projections for inflation were lowered to 1.6% from 1.9% in 2017, the dot plot didn’t change. Fed members still expect one more rate hike in 2017 and three in 2018. More interestingly, policy makers set out a detailed plan to shrink the $4.5 trillion balance sheet by gradually reducing security holdings. Although the date has not been specified, there’s a very high chance the process will start in September.
It seems the Fed is no longer data dependent as before and wants to carry on with the normalization process despite weakness seen in some economic releases. Yesterday’s CPI and retail sales were both disappointing but didn’t seem to worry Yellen.
This disconnect between what the markets expect and what the Fed is signaling may be explained in two theories. It’s either that the recent wobble in economic data is temporary and the next two months should prove it, or the Fed wants to have enough tools in case the economy fell into a new recession.
Although the dollar rallied after the statement release and Yellen’s speech, the dollar index is still trading near a seven-month low. Fixed income traders are clearly unconvinced with the Fed’s hawkishness. U.S. yields dropped across the curve on Wednesday and the spread between two and ten-year yields shrank to the lowest levels in over a year. However, equity investors seemed to take Yellen more seriously sending cyclical stocks lower driven by the tech sector. Many U.S. stocks will be vulnerable to an ongoing tightening in financial conditions especially those with overstretched valuations.
BoE rate decision
Attention today will shift to Bank of England’s decision, and how policymakers will respond to the drop in consumer spending, negative real wages, and inflationary pressures. The weaker pound’s impact on Britons’ living standards started to reflect in the latest data releases and today's retail sales figure may fall sharply after increasing 2.3% in April. The BoE might underestimate the recent spike in prices, but if two or three MPC members see a need to follow the Fed by hiking rates the pound will appreciate sharply. However, with the increased risk of political turmoil, it's highly unlikely that the BoE will hike rates anytime soon unless inflation went out of control. Overall, I think politics will continue to be the primary driver for Sterling in the foreseeable future.