Fed Hikes Interest Rate by 25bp

What happened

• The Fed raised short term interest rates by 25bp to a range of 0.75%-1.00% as widely expected while maintaining the status quo on “dot plots” for normalization, leaving 2017 and 2018 unchanged for 3 hikes and raising the 2019 median marginally to 3%.

• The rate hike was accompanied by no upgrade in language on activity though core PCE inflation was modestly upgraded from 1.8% to 1.9% for 2018. In her press conference following the decision, Fed Chairwoman Janet Yellen noted that the economy continues to expand at a moderate pace and job gains should strengthen further while also stressing that policy will remain accommodative for now given that improved sentiment was still not seen to accelerate consumer or business spending.

• With the fall in US short rates, the market is now pricing a less than 50% probability of a June hike with only September fully discounting one hike and discounting a total of a further one and a half hikes for the year (versus Fed dot plots for two more).

Market Reaction

• US Treasuries prices moved higher following the Fed's decision, as the yields on the 2 and 10-year note fell 8 and 11bp respectively and the 30-year bond yield declined 8 bps to 3.09%

• The US dollar surged with the Dollar Index – a comparison of the US dollar to six major world currencies – fell 1.0% to 100.71.

• Given more dovish than expected Fed outcomes, US equities rallied with the S&P 500 index rising 0.84%.

Citi’s Views

• Citi analysts expect the current retracement in US Treasuries and USD to continue in the near term (targeting UST 10Yr yields to 2.35%) that sees markets currently discounting somewhat less than 3 Fed hikes for this year.

• But Citi analysts also remain of the view that the Fed may hike three times this year, most likely in June and September and that balance sheet reduction could be announced in December.

• The lack of new information on balance sheet reduction in the FOMC statement overnight suggests slower progress than expected, but the FOMC minutes (released April 5) may be more informative on this point.

Market Implications & Investment Strategy

Citi analysts maintain their current investment strategy: overweighting US dollar assets while keeping a small tactical overweight in both cash and gold. They remain slightly underweight both global equities and global fixed income while assessing investment opportunities amid fast-changing market valuations and speculation over new policies.

• US dollar: With the UST short end now pricing a less than 50% probability of a June hike with only September fully discounting one and markets only discounting an additional one and a half hikes for the year (against the Fed’s 2), any further substantial reversal may provide medium term buying opportunities in USD

• Equities: Citi analysts see the Fed's interest rate hike as a vote of confidence in the US economy given positive trends in the labour market, consumer and business confidence. As long as the Fed continues to move rates in line with economic developments, and does not seek to hike aggressively to curb inflation, businesses can absorb higher short-term borrowing costs and continue to see earnings growth. Citi maintains a full neutral position in US equities while underweight Europe. Japan is maintained at neutral. Recent indications of a broadening and strengthening of the EM recovery, especially in Asia's more manufacturing-export economies, is likely to now become the principal driver of investment decisions. While some risks remain — especially from European political developments — for now emerging markets may have a reasonably clear path to outperform in the short term.

• Bonds: Looking ahead, Citi strategists think that the post Fed rally is likely with the 10y yield to retest 2.35% over the next few weeks given that the market may continue to price in a terminal rate around 2% in the near term. With a potentially gradual interest rate hike path in the US, Citi analysts think that yields remain globally appealing while US credit market valuations have risen significantly and continue to favour hedging floating-rate liabilities and look for opportunities in US high yield variable-rate bank loans.