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Strongly surprised by the Fed hawkish tone, markets react quickly: USD and yields both increase

20 December 2016

Global market sentiment was positive this week.

All major equity indices increased except emerging markets who stayed under pressure: US equities rallied to new record high and European markets erased 2016 losses. Bond yields rose sharply.

This week markets' attention was focused on the US Federal reserve meeting :

  • The FOMC meeting caught markets by surprise with an hawkish shift. As widely expected, the Federal Reserve raised the target range for the federal funds rate by 25bp to 50-75bp for the second time in this cycle but announced faster than expected tightening of the monetary policy
  • The major change came in the Summary of Economic Projections, which showed a faster path of rate hikes in 2017. Policy makers now anticipate three hikes for each of the next three years
  • This shift was hawkish and markets reaction was strong :  the dollar jumped to highest since 2003 (against Yen and Euro mainly) and the US2Y treasury yield hit a seven year high. Moreover, Janet Yellen, chair of the Fed, highlighted that FOMC projections do not incorporated any fiscal policy expansion and any potential Trump stimulus yet 
  • Nevertheless, Chair Yellen downplayed the change, saying the firming in the median rate path in 2017 was modest and only represented a small shift in the thinking of several committee members 

In the macro economical side, surprises continued to be positive and supported the global market sentiment :

  • In the US,  inflation pressure increased further as positive energy base effects continue to boost the Consumer Price Index (fourth consecutive month of increase) and Producer Price Index rose at a solid pace in November and exited form deflation (+1.5% YoY). Moreover, expectations of restrictive trade policies and substantial fiscal spending should support inflation over the medium term
  • Following the earlier strong manufacturing indicator (PMI) and trade data, Chinese activity data came in better shape than expected. All of that suggest upside growth momentum for the fourth quarter 
  • In Europe,  manufacturing indicators continued to show improvement of activity for the end the year. The full 4Q average is the best quarter this year, standing at 53.7 (composite PMI) compared with 52.9 in the previous quarter
  • Moreover, oil prices remained firm this week supported by the decision of non-OPEC producers to join OPEC in the production cut 

All that being said, what do we think?

  • Regarding inflation and growth: Inflation outlook has firmed since mid-year and should continue to improve. The path of rate hikes is modestly steeper than in September as the US economy remains strong 
  • One of the questions is to know if this reflation rally could continue much longer or is overdone?
  • The hawkish shift from the Fed could support a continuation of the reflation theme in a short term  
  • But, when we look at markets, we think that an important part of the post-election market re-pricing is based on speculation about what the President or Congress could implement. Many of potentials positive effects of Trump’s policy seems to be already priced by markets 
  • This bullish run was both quick and strong but tax reform and more expansive government spending are more likely to influence the 2018 outlook rather than 2017 
  • At time of writing, technical indicators telling us that markets are overbought (equities, dollar) and treasuries yields oversold. Sentiment is very greedy and markets stayed in a very positive mood for the moment. Some valuations are expensive and market positioning is not light. 
  • There is few place for potential disappointments. Policy normalization should remain very gradual. Some headwinds remain: strong dollar, weak international growth/geopolitical risk 
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