After ECB's Hawkish Cut, Is the Fed about to Deliver a Dovish Hike?

After much hemming and hawing since mid-year, the Federal Reserve is finally poised to raise rates for the first time in nearly a decade. Indeed, given the speeches by the leadership and the economic data, especially the labor market readings, the failure to raise rates would likely be more destabilizing at this juncture than lifting them.

Surveys of market participants suggest that a Fed hike is as done of a deal as such an event can be. A recent Reuters survey found all but one primary dealer expects a hike this week. A Wall Street Journal poll found 97% of professional and academic economists also expect the Fed to raise rates this week. That is a five percentage point increase from last month and 10 from October.

It appears that many are looking past the decision itself. The FOMC statement's economic assessment is unlikely to change very much. The economy is performing largely in line with its expectations. In this context, we note that after retail sales and inventory data, the Atlanta Fed's GDPNow tracker has Q4 GDP expanding at 1.9%, up from 1.5% the previous week. This is generally thought of as trend growth for the US, given the slower productivity and labor force growth.

The Fed has been at pains to drive home two points to investors. First that the pace of rate increases is expected to be gradual and dependent on the evolution of economic activity. In September, gradual was operationally defined by the dot-plots as 25 bp a quarter (every other meeting) in 2016 and 2017. The market will be looking at the new forecasts to see if this is still the Fed's thinking. A few investments houses, and Fitch, the rating agency, have also forecast four hikes next year.

The second point Fed officials have stressed, and will likely to be repeated at the end of the new FOMC statement, is that the terminal rate or the peak in the Fed funds target will probably be lower than in past cycles. Again, the dot-plots suggest that officials expect the Fed funds to peak near 3.75%. The market, as reflected in the Fed funds futures and OIS market expects considerably lower rates.

In the past, the real Fed funds (adjusted for inflation) had to be near zero or below before the US economy recovered from a recession. In this expansion, the market does not expect Fed funds to be positive in real terms. The implied yield of the December 2016 Fed funds futures contract is 77 bp. The Dec 2017 contract implies 127 bp and June 2018 is at 147 bp.

A significant challenge to using the Fed funds futures contracts to interpolate expectations of Fed policy is that the contracts settle at the average effective rate for the month, not the policy rate. Now that Federal Reserve has adopted a target range for the Fed funds rate, the it is an open question of where Fed funds will average after a hike. At the zero-bound (current target range is 0-25 bp), the Fed funds have averaged around the mid-point of the range 12-13 bp.

What Fed funds average after lift-off is an open question. Many popular models simply assume that the midpoint achieved on average. However, to drive home the point of gradual hikes, and to maximize the attractiveness of interest on excess reserves, which did not exist before the crisis, suggest the risk sufficiently liquidity is provided by the Fed to keep the funds rate on the soft side of the midpoint.

The Fed's dot-plots, which we argue, has a high noise to signal ratio, may be particularly important this week to help shape expectations of the next hike. Bloomberg calculates that the March Fed funds contract are implying about a 35% chance for a second hike. The Wall Street Journal polls found nearly 2/3 (65%) of the private sector professional economist expect the Fed to deliver the second hike in March. In November, only half (49%) expected a March hike. Another 14% expect the second hike to be delivered April (when the FOMC meeting is not accompanied by an update in forecasts or a press conference).

One of the implications of this review is that, although the divergence meme is widely recognized, it is hard to conclude that it has been fully discounted. This underpins our medium and longer-term bullish dollar outlook, but it does not stand in the way of a continuation of the near-term dollar correction. Our review of the speculative positioning in the futures market indicated much to our surprise that the dramatic rally in the euro (and other currencies) in response to the ECB action failed to reflect a significant adjustment of short exposure.

The price action and technical indicators also support this conclusion. After rallying since the middle of October, the dollar's correction does not appear to be complete. Year-end considerations, including the diminished participation and liquidity, may exacerbate the pain-trade of further dollar losses.

In terms of the decision to hike rates itself, among the voting FOMC members there could be as many as three dissents. This would include Governors Tarullo and Brainard, and Chicago Fed President Evans. All three have voiced objections to a hike under current conditions. A dissent by regional Fed president is commonplace; from a governor, less so. A unanimous decision is obviously preferable but seems decidedly unlikely. However, fewer than three dissents may speak to Yellen's leadership skills.

The FOMC is the highlight, but there are five other important developments that will help shape the investment climate:

1. Before the weekend, China announced that it would place more emphasis on maintaining the yuan's stability against a basket of currencies rather than simply the US dollar. Officials have made similar pronouncements in the past; what it means in practice is yet to be seen. The conclusion many have drawn is that this will allow the yuan to depreciate further against the dollar. While we don't disagree with this assessment, we note that the yuan has steadily fallen against the dollar over the past six weeks. Remember the dollar finished last week at four-year highs against the yuan before the announcement. It is as if China had already operationalized the policy and was just getting around to announcing it.

The political and ideological chits earned by downgrading the role of the dollar are minor at best. China is trying to spin the necessity as a virtue. The US Treasury appears to have been one of the sustained voices calling for the abandonment of the reliance on the dollar (and the accumulation of Treasuries that has implied). Real money flows will still be moved and liquidity transferred in bilateral currency terms, not the index that China may prefer. When it does enter the SDR, it will still be providing the dollar-yuan rate to the IMF on a daily basis.

The issue here is not really about the yuan's exchange rate or the dollar's international role. Instead, it is about China trying to de-couple from US monetary policy as the Fed prepares to begin a tightening cycle. The link between the yuan and dollar is an important channel in which monetary impulses are transmitted. Given the divergent needs, the linkages to US monetary policy no longer serves China's interest. The conclusion of many international investors is that Chinese officials botched the mid-August attempt.

2. Three other major central banks meet in the week ahead: Sweden's Riksbank, Norway's Norges Bank and the Bank of Japan. There is most confidence in the outcome of the BOJ meeting. No change is expected. The Riksbank and Norges Bank meetings are live, meaning that a change in policy is reasonable.

The Riksbank deposit rate is set at -35 bp. While it could cut, we suspect it may choose to keep its powder as dry as it can be said when it is so far through the zero-bound. At the same time, it could expand its bond buying program by SEK5-SEK10 bln. The euro had been trending lower against the krona but appears to have carved out a bottom. There is scope a one-two percent recovery of the euro of the next couple of weeks.

Whereas the Riksbank is concerned about deflation, the Norges Bank's challenge is with growth as the drop in oil prices reverberates through the economy. The continued drop in oil prices and a series of disappointing economic data may spur the Norges Bank to cut its deposit rate from 75 bp to 50 bp. The euro is already sitting just below the year's high against the Norwegian krone. Further gains are likely.

3. Eurozone data includes the flash PMI, October's industrial production and final read of November CPI. With the ECB out of the picture, given the recent action and the completion of the December TLTRO, the economic data may lose some of it market-moving potential. There will be some allowances also made for some softer sentiment data, including the German IFO, for disruptions following the October 31 attack.

There are several UK economic reports in the week ahead. They cover prices (CPI and PPI), consumption (retail sales) and the labor market. CPI is close enough to zero to not matter very much whether it is plus or minus a little; it is the same thing for all practical purposes. While the labor market is expected to be little changed, confirmation that the upward pressure on average weekly earnings is dissipating may be understood as further pushing out a BOE rate hike, and weigh on sterling's exchange rate. If the Bloomberg consensus is right that the year-over-year pace of UK retail sales slows to 2.3% (excluding petrol), it would be the slowest pace in two years.

Japan starts the week with the quarterly Tankan Survey. It is widely seen as one of the most authoritative surveys of Japanese businesses. The market expects little change to slightly softer results. It is unlikely to have much impact, barring a significant surprise. Capital expenditures are particularly volatile, and it is partly owing to capex that Q3 GDP was revised from contraction to expansion. The capex plans reported in the Tankan survey may draw attention.

In the middle of the week, Japan reports the November trade balance. For the past eight years without fail, the November trade balance was worse than October and this year is unlikely to break the seasonal pattern. Indeed, after the six-month streak of trade deficit was snapped in October, it is likely to have reverted to a deficit in November. More important than the balance is the performance of exports and imports. Merchandise exports fell 2.2% in October (year-over-year), the first decline in August 2014. They are expected to have remains negative in November. Imports pick up the decline in energy and commodity prices. Due to the base effect, the decline is moderating.

4. The market has upgraded the risks that the Bank of Canada will deliver another rate cut in late-Q1 or early-Q2. Investors will likely respond to data by looking through such a lens. Since December 4, the implied yield of the June 16 BA futures contract has fallen by about 17 bp. The Canadian dollar is the worst performing major currency this year, losing about 15.5% so far. Its 3.2% loss thus far this quarter is also the most among major currencies. The same is true of its 2.8% decline here in December.

The decline in oil prices, the increasing US interest rate premium, and weaker equity markets align the fundamentals against it. Also, the macro-prudential measures the government announced before the weekend (raising required down payment on home purchases of more than C$500k) is seen, on the margins, it increase the risk of a rate cut by removing a potential obstacle (overheating housing market).

5. While it may be tempting to link the emerging market sell-off to the prospects of Fed tightening, we argue it is considerably more complicated. The dollar's more than 10% rally against the South African rand had less to do with what the US was doing and much more with the dismissal of a market-respected finance minister, even as the country teetered on losing its investment grade status.

The Brazilian real is the worst performing emerging market currency this year, losing nearly a third of its value (31.4%) against the US dollar. While some small fraction this may be due to considerations about the US monetary policy outlook, the bulk is largely a product domestic politics and falling commodity prices, related to slower Chinese demand.

While we have expressed our doubts with the emerging markets as an asset class, we have noted that a more differential view is required. This insight will be driven home in the days ahead when eight emerging market central banks meet. Hungary, Indonesia, and the Philippines will stand pat by nearly all reckoning. There is a slightly greater risk that Taiwan and Thailand central banks ease policy (note that Taiwan often moves in 12.5 bp increments).

Colombia is most likely to hike rates. It has done so in each of the past three meetings. While there was a 50 bp hike in October, the Bloomberg consensus expects a 25 bp move as in September and November. On the other hand, the dollar's 8.3% appreciation of against the peso since the rate hike make warrant a larger move. Chile's central bank meets. It hiked rates in October from 3.0% to 3.25%. The Bloomberg consensus does not expect another hike.

The outlook for Mexico's central bank is more controversial. The weakness of the peso and official comments have fanned expectations that on the day after the Fed hikes rates, Mexico will do the same. This is the Bloomberg consensus. Given that the peso's weakness has not spilled over to boost prices, the urgency to follow suit is not immediately evident.