Fed prepares the market for the resumption of rate hikes – MUFG

Lee Hardman, Currency Analyst at MUFG, notes that the US dollar has strengthened sharply following the release overnight of the more hawkish than expected FOMC minutes which sent a clear signal to market participants that they had become too complacent over the likelihood of further Fed rate hikes this year.

Key Quotes

“The minutes revealed that “most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labour market conditions continuing to strengthen, and inflation making progress towards the Committee’s 2% objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June”. The strength of signal was surprising to even our more hawkish expectations.

We have been expecting the Fed to resume rate hikes in either July or September and viewed the June meeting as likely too soon especially as it falls just before the EU referendum in the UK. There is now clearly a high risk that the next rate hike is delivered in June. Some participants noted concern over Brexit risk in the minutes but it did not appear likely to be a significant impediment to a rate hike in June.

Diminished downside risks from global and financial market developments have prompted the Fed to quickly shift its policy focus back towards more favourable domestic fundamentals. The minutes revealed that “most” participants expect the US economy to rebound in Q2 and view the weakness evident in the Q1 GDP numbers as unreliable. “Most” participants also expect inflation to rise to their 2% goal in the medium-term.

The US interest market has subsequently adjusted to discount a higher likelihood of a rate hike in June (at around a third). It will make the Fed more comfortable to raise rates if required now that the market is better prepared. With a rate hike still not fully discounted even by September there still appears scope for the US dollar to strengthen further in the near-term if the Fed backs up its words with action. It would reinforce our outlook for a stronger US dollar.

In light of the more hawkish message from the FOMC minutes overnight, we will be watching closely speeches today from Vice Chairs Dudley and Fischer. If they provide a signal on monetary policy it is likely to be consistent with the message from the minutes that June is a live meeting for a rate hike.”