The most important takeaway from yesterday’s meeting was that the Fed continued to signal only three more rate hikes in 2018 despite revising up growth forecasts to include the impact of fiscal stimulus from the proposed tax cuts currently being discussed in Congress. This suggests that the pace of future rate hikes will be more sensitive to inflation than growth.
As expected, the Federal Reserve (Fed) raised short term interest rates for the third time this year. The Federal Open Market Committee increased the target range for the federal funds rate by 25 basis points to 1.25-1.5%. The S&P 500 ended the day little changed and the Dow Jones Industrial Average was up 0.3%, closing at a record high. The dollar index declined 0.7% while US 10-year yields were little changed at 2.346%.
The most important take away from yesterday’s meeting was that the Fed continued to signal three more rate hikes in 2018 despite revising up growth forecasts to include the impact of fiscal stimulus from the proposed tax cuts currently being discussed in Congress.
This suggests that the pace of future rate hikes will be more sensitive to inflation than growth.
On the inflation front, the US CPI report for November, which was released yesterday, was relatively weak. Core inflation advanced 0.1%, below consensus and Citi’s expectations. While Citi analysts still expect stronger monthly inflation ahead, they acknowledge that the pace of rate hikes could slow if inflation remains subdued.
What does this mean for investors?
Given Citi’s current projections, we are 45% through the hiking cycle. Historically, from this point till the end of the cycle, Citi analysts note that risk assets have continued to grind higher with range bound volatility while US yield curves flatten, driven predominantly by the short end. The US dollar has also historically remained range-bound while broad commodities rise.
With interest rates expected to rise gradually, Citi analysts continue to favor equities over bonds in 2018. With the S&P 500 trading at 18x 2018 earnings, Citi analysts prefer the less expensive Emerging Market and European equity markets. Within bonds, higher yielding US investment grades and high yields, as well as emerging market debt are expected to provide more buffer against rising interest rates. Citi is bearish on the USD as rising economic growth rates in Europe and Japan reduce the cyclical support enjoyed by the dollar. Citi analysts also expect robust economic growth and tight supply to lift metal prices, which leads them to favor the materials sector.