It’s the path that matters
We expect to see the target range of the federal funds rate raised to 0.75%-1.00% in the March 16 FOMC meeting (5:00am AEDT) and a hawkish dot plot. Markets appear to have priced in a 100% chance of a hike in March leaving the focus primarily on how the Fed presents the path beyond the meeting.
We expect the Fed to undergo a gradual rate path and tolerate increasing inflationary pressures due to inflation undershooting since the GFC but see more hikes over 2017-2018 than currently priced in. There is still significant risk and uncertainty around the Administration’s policies but data has supported the argument to hike in March.
Markets will be watching the dot plot to assess the rate path. Our base case sees the median path for 2017 unchanged while the 2018 median should make a hawkish shift higher. Currently there are around 3 hikes in 2017 and 2 in 2018 priced in. Any shift up in the mean or median dot forecast could see markets react by pricing in more hikes. Markets may not move to meet the median dots but any change in the direction of the rate path is what is important. In the scenario where markets do meet or even exceed the dot plots risk assets will likely come under severe pressure. Any pricing in of more hikes in 2017 and 2018 would be a bullish influence on the USD.
In the scenario where we do see the 2017 dots mean and 2018 dots median rise, the 2s5s curve should steepen as both points on the curve yields rise. In the currency space, the most sensitive pairs to such a shift are the USDJPY and EURUSD which have the highest beta to both the 2y yield differential and relative 2s5s curve steepness while we find GBPUSD to be quite resilient. We see further upside to USDJPY as the BoJ remain on the sidelines and maintain our bearish EURUSD view.