Fed: The stage is set - BBH

Research Team at BBH, notes that there were significant moves in interest rates and currencies last month and the drama was primarily spurred by the solidification of expectations of a Fed hike in the middle of this month and the stimulus promised by President-elect Trump. 

Key Quotes

“After years of falling budget deficits, the prospect for fiscal stimulus by the new President may have forced up long-term yields in any event.  However, the prospect of stimulus while the US economy enjoys trend growth and full employment is a different matter.  The incoming president has promised a package which, as a percentage of GDP, appears to rival the 2009 stimulus when the US economy was in the throes of a deep economic downturn.  This in turn implies a greater demand for capital than the 1.80% yield on the US 10-year Treasury that prevailed before the election reflected.  Part of the increase in yields is due to an increase in the inflation premia, and part of it reflects an increase in the real cost of capital.”

“At the same time, evidence has accumulated indicating that the inventory and manufacturing-led economic soft patch has been overcome.  Business investment also appears to have bottomed, and the recession in corporate profits has eased.  There is little doubt that the Fed will hike rates for the second time in the cycle in a couple of weeks.  The rise in US yields at both ends of the helped drive a sharp widening of the interest rate differentials.”

“These developments have helped fuel a strong dollar rally.  The Federal Reserve's real broad trade-weighted index, which is the best measure used to assess economic impact, rose by almost 2.3%, just edging out the January rise, to be the biggest advance to Lehman failed.   The yen was the weakest of the major currencies, depreciating by 8.4%.  The euro lost 3.6%.  The Canadian dollar fared better than most, losing only 0.2%, underscoring one of our rules of thumb: in a strong US dollar environment, the Canadian dollar typically outperforms on the crosses.”

“The table is set.  Fed officials will draw confidence from the drops in the unemployment and underemployment rates, and the continued solid (even if not spectacular) job growth.  Average hourly earnings disappointed, but the trend has been good, and many will expect more wage pressure going forward.  The economic calendar turns light in the week ahead.  There are several Fed officials who speak before the cone of silence is invoked ahead of the FOMC meeting.  Separately, with the announcement of the Treasury and Commerce Secretary nominees, non-economic news is likely to dominate in the days ahead.”