Fed's mildly hawkish stance underwhelms markets

Philip Wee, FX Strategist, DBS Bank and Eugene Leow, Rates Strategist, DBS Bank

Overnight, USD rates were sanguine as the Fed delivered a 25bps hike (taking the Fed funds rate ceiling to 1.75%) while projecting a steeper tightening path for 2019 and 2020 (taking Fed funds rate to 3.4% by the end of the period). Broadly, the dot plot appears to be consistent with projections for higher GDP growth (revised up to 2.7% and 2.4% for 2018 and 2019 respectively) and core PCE inflation (revised up to 2.1% for 2019). Notably, the median projection for 2018 stays at three hikes, easing fears that rate hikes would be aggressively frontloaded. After the sell-off over the past few months, USD rates are probably close to neutral with the market requiring greater evidence of growth / inflation before taking USD rates another leg higher. Notably, while the Fed sees five-to-six hikes by end-2020, the market is only willing to price in another three-to-four.

Longer-term estimates of growth, inflation and the long-run Fed funds rate were broadly left unchanged. The Fed's forecast is suggesting that the cyclical upturn may necessitate tighter monetary policy (above the long-run rate) in the next few years. We remain neutral on USD rates in the short term but continue to see a drift higher in the coming quarters. Longer-term rates are no longer complacent on inflation risks. CPI data has moderated in February while 5Y breakevens are already firmly above 2%. Higher inflation or increasing budget deficit worries would be needed for 10Y yields to convincingly push past 3%. That said, we suspect that the belly of the curve (2Y, 3Y) is likely underestimating tightening risks.

The currency market was underwhelmed by the Fed's upgraded economic assessment. The US dollar, as measured by the DXY Index, ended yesterday lower at 89.8 from 90.4 on Tuesday, back to last week's levels. The disappointment revolved around the Fed's 2018 forecasts, where the upgrade in its real GDP growth to 2.7% from 2.5% was not accompanied by higher projections for the Fed Funds Rate (kept unchanged at 2.1%) and inflation (unchanged at 1.9%). The Fed maintained its bias for three hikes this year and opened the door for four hikes in 2019, the year that it expects core PCE inflation to push above 2%. Hence, there was no incentive for the US 10-year treasury yield to rise above the 2.80-2.95% range established since early February.

It is premature to conclude that the US dollar will resume its downtrend. Fed's steady series of rate hikes will keep US rates on a divergent path with its G4 peers over the next couple of years. More importantly, the US growth outlook has also widened its gap with its counterparts. While the European Central Bank has upgraded its 2018 growth forecast to 2.4% from 2.3%, growth is still slower compared to last year's 2.5%. Similarly, the Bank of Japan has maintained its growth forecast for fiscal 2018 at 1.4%, down from 1.7% the previous fiscal year. We remain mindful that it was the upside surprises in EU growth that lifted the euro (the largest component of the DXY) and hurt the US dollar in 2017. Unless the US 10-year yield falls, we don't expect the DXY to deviate too far below its psychological 90 level for now.

Source : Equity Bulls

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