Market Flash: A More Optimistic Fed

A more optimistic FOMC

The FOMC raised short term interest rates by 25bps as widely expected but the markets reacted negatively to the Fed’s revised projections of a faster pace of tightening. US equities and bonds declined while the US dollar rallied.

What happened?

• The FOMC raised the Fed funds rate target range by 25bps to 0.50-0.75% as widely expected but surprised the market with a slightly faster trajectory of expected rate normalization in 2017.

• The median projections for the funds rate showed three rate increases next year, up from two at the September meeting. Longer-run projections for the funds rate also edged up, with the median rising to 3.0% from 2.9% previously.

• The post-meeting statement indicated that an increase was warranted as labour market conditions and inflation were approaching the Fed’s target levels. However, Fed Chair Janet Yellen stressed that rates were expected to rise only gradually.

Market Reaction

• Treasuries moved sharply lower following the Fed decision, as the yield on the 2-year note rose 10 bps to 1.27%, hitting its highest level in 7 years. The yield on the 10-year note jumped 9 bps to 2.57%, while the 30-year bond rate added 5 bps to 3.18%, respectively.

• The US dollar surged with the Dollar Index—a comparison of the U.S. dollar to six major world currencies— climbing 1.2% at 102.2, the highest in 14 years.

• The reaction in US equities was relatively more muted. The S&P 500 index fell 0.81%.

Citi's Views

• Citi analysts maintain their stance of projecting two (not three) rate increases for 2017.

• In Citi analysts’ view, post the US election, investors and the markets have priced in the possibility of a sizable fiscal stimulus taking place sooner rather than later. This ignores the legislative and implementation lags in the timeline for tax reform and infrastructure spending.

• In contrast to current market pricing, Citi analysts believe any fiscal stimulus is likely to impact US GDP and inflation later rather than sooner.

• In fact, Citi analysts expect the drag from sustained higher interest rates and the strong dollar to dent some of the FOMC’s optimism and potentially cause delays again in the Fed’s rate hike cycle in 2017.

Market Implications and Investment Strategy

Despite the Fed’s projections of more rate hikes in 2017, Citi analysts maintain their current investment strategy:

• Equities: Although equities saw modest declines, Citi analysts do not expect a repeat of the larger sell-off that followed the Fed's last rate hike in December 2015 given positive growth in US corporate earnings and potentially higher oil prices. We remain neutral on equities in the US and Japan while maintaining an underweight in Europe given political risks ahead. We maintain a small overweight position in emerging market equity preferring Lain America. Higher rates and strong US growth may support the financial sector and cyclicals.

• US dollar: Higher US interest rates and an easier fiscal policy may continue to support the US dollar. Citi analysts expect the USD to gain 6-7% against the G10 currencies and 3% versus EM currencies. However, rising uncertainty over US policies in 2017 may give rise to greater volatility in the dollar.

• Bonds: The risk of higher bond yields lead Citi analysts to remain underweight in low yielding developed market government bonds. While Citi analysts have trimmed their durations around 7 years, they see opportunities in the current bond sell-off. Citi analysts continue to like US high yield bonds as well as investment grade bonds. Heightened political risks in Europe in 2017 is likely to create volatility within European financials, but longer term investors can find value in Swiss, Dutch, French and UK International banks. Emerging Market debt is still expected to deliver positive returns over the next year.