The Federal Open Market Committee’s (FOMC) 19-20 September 2017 meeting has left short-term interest rates unchanged, increasing probability of a December rate hike. As expected, Fed Chair Janet Yellen has also announced that the Fed will begin unwinding its balance sheet.
Fed likely to increase rates in December
Fed rate ‘dots’ – which indicate where policymakers believe policy rates should be at the end of each year – showed more support than expected for a third rate hike in 2017: 12 Fed officials still want to hike at least once more in 2017 and no officials joined the four who in June were already calling for two hikes in 2017.
This – together with Chair Yellen’s characterisation of recent lower-than-expected inflation as transitory in the press conference – increases Citi’s confidence that the FOMC will increase rates in December.
But the more important inflation outlook came from Chair Yellen’s statements at the press conference, which characterised the recent run of weak core inflation data as "primarily reflecting developments not related to broad economic conditions". Rather – in Yellen’s view – many of the factors that have weighed on inflation are "idiosyncratic" and will "fade away". This is in line with Citi’s views.
US equities took the prospects of another rate hike in 2017 in their stride. The Dow Jones Industrial Average (DJIA) increased 0.2% to 22,413 and the S&P 500 Index gained 0.1% to 2,508. Citi analysts have a neutral outlook on US equities within a diversified portfolio. While corporate earnings are expected to grow 9% in 2018, current valuations at 20x 2017 price-to-earnings ratio look stretched.
The US 2-year and 10-year Treasury yields moved four and three basis points higher respectively as the market priced in a faster pace of hikes. The probability of a 2017 December rate hike increased from around 50% a week ago to 65%. Citi analysts expect the 10-year US Treasury yield to end 2018 at 2.75%. As yields move higher, this could raise volatility in selected bond sectors. In particular – while Citi analysts remain moderately overweight on US high-yield corporate bonds, with spreads at post-crisis lows – income-seeking investors can consider diversifying into emerging-market debt, US investment-grade corporate bonds, non-agency residential mortgage-backed securities and high-dividend-yielding European equities.
While the dollar index appreciated 0.8% after the Fed meeting, investors may want to temper their longer term outlook for the US dollar. While the dollar can still rally in the short-term on the back of quicker progress on US tax reforms or heightened geopolitical risks, Citi analysts believe that the longer term trend for the dollar is down. This comes about as the US economy runs persistent and larger twin deficits and the momentum in other foreign economies pick up. Citi analysts’ subdued outlook for the dollar is one of the factors underpinning Citi’s positive outlook for emerging-market assets.