Will the US Fed hike rates in its December meet?

With the US electing Donald Trump as their 45th president, the question is whether the Fed would still go ahead with rate hikes. It was already predicted by most pundits that Fed would go ahead and hike rates in December. Global fund managers like Mohammed El Erian are of the view that Trump could trigger a consumption and investment boom in the US which will be instrumental in taking inflation higher. That will give a good reason for the Fed to hike rates in December.

It may be recalled that the US Fed had focused on 3 principal criteria to decide on a rate hike viz. near-full employment, rising inflation and rising growth & consumption. The unemployment is currently in the range of 4.8-4.9%, which is at a multi-decade low. Inflation is still low, but that is more due to low oil prices. With Trump planning to invest $1 trillion on infrastructure and cut corporate and individual taxes, inflation may start rising sooner rather than later. That could have a salutary impact on growth and consumption too.

Let us look at 3 key indicators that give a credible signal of the Fed intent to hike rates…

Indicator 1: Fed Fund Futures probability of rate hike…

1The above chart shows the probability of a rate hike as implied in the Fed Funds futures that are traded on the Chicago Mercantile Exchange (CME). The Fed funds are currently in the range of 25-50 bps; which was effective the last hike in December 2015. The above chart indicates that there is an 81.1% probability of the Fed Funds rate being hiked by 25 bps to the range of 50-75 bps in the December 14th meeting of the Fed. Normally a probability of over 70% is considered to be a very high likelihood that the Fed Funds rate will be hiked by around 25 bps.

Indicator 2: How the dollar index (DXY) moved in the last 1 month…2

The dollar index is depicted in the Bloomberg chart above. The Bloomberg Dollar Index (DXY) is the value of the US$ measured against a basket of global currencies. Normally a rise in the index implies a strengthening of the dollar vis-à-vis other currencies and a fall in the index implies a weakening of the US$ vis-à-vis other currencies. The DXY has shown a sharp rise since the beginning of November and that is clearly predicated on the likelihood of a Fed rate hike. Typically a Fed rate hike results in greater demand for dollar debt and therefore a strengthening of the dollar. This is another indicator that points towards a high probability of a Fed rate hike in December.

Indicator 3: How the US 10-year G-Sec yields have panned out…

3Over the last 1 month, the yields on 10-year US bonds have gone up by over 45 bps from 1.75% to 2.21%. We all know that there exists an inverse relationship between interest rates and bond prices. In anticipation of a rise in Fed fund rates, the prices of US bonds have started falling which has resulted in the benchmark bond yields going up. A sharp movement of 45 bps in bond yields as we have seen in the last 1 month is indicative of a very high probability of Fed fund rates being hiked in the December meet.

Donald Trump and the future of Fed fund rates…

The rate hike in December is almost a certainty, at least going by the indicators like the Fed Futures, US Dollar index and the 10-Year benchmark yields. A 25 bps rate hike is virtually factored into markets across the globe and hence may not come as a major surprise. The big question is what happens after that. There are 3 points to remember here:

  • Firstly, the Trump government has pledged to invest nearly $1 trillion in American infrastructure which could set off a virtuous cycle of investments and capital spending. This will pre-suppose access to substantial funds at very reasonable rates of interest.
  • Secondly, the Trump government plans to put a lot of money into the hands of people by cutting corporate and individual tax rates. This could most likely trigger off a consumption boom across America. That would push inflation up and make a case for further rate hikes.
  • Lastly, the Trump government despite all its inward looking claims cannot remain immune to the world economy. With most economies across Europe, Japan and China slowing, any hawkish persistence by the US Fed risks monetary divergence.

In conclusion, it appears that despite the rate hike in December 2016 the trajectory of rates will continue to be lower than what was originally anticipated. With Trump adopting a pro-business approach, further Fed rate hikes from here on could be capped. That could be the good news for the world economy!

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