USD: Market reaction to Trump keeps Fed on track - MUFG

Derek Halpenny, European Head of GMR at MUFG, notes that The dollar gained further yesterday and with the S&P 500 now up 4% from the low last week, the probability of the FOMC raising rates at the next meeting on 14th December remains high at around 75-80%.

Key Quotes

“The 5yr/5yr inflation swap rate has surged to 2.5%, just surpassing the peak from 2015 and taking us back to levels last seen in December 2014. The 30-year UST bond yield has surged to close to 3% and to levels not seen since the beginning of 2015.”

“For those reasons we shouldn’t be at all surprised that the first rhetoric we have heard since Trump’s victory indicated that the FOMC remains on track to hike next month. St. Louis Fed President Bullard stated yesterday that a ‘single rate increase’ in December would be a “reasonable time” to do it. Bullard will be a voter at that meeting. In addition, Richmond Fed President Lacker (non-voter this year and next) stated that the case for raising the fed funds rate remained “relatively strong”. Next Thursday will be crucial for the markets in regard to monetary policy expectations with Fed Chair Yellen now scheduled to testify on the economic outlook to the Joint Economic Committee of Congress. This will be intriguing in the aftermath of Trump’s election victory given his explicit criticism of the Fed’s monetary stance as being politically motivated in order to support President Obama and a victory for Hillary Clinton.”

“It will be intriguing for the US dollar as well. In Yellen’s last speech in October she outlined the possible monetary strategy of allowing the economy to “run hot” as a means of healing the growth problems of the economy. The implication of that comment is that the FOMC would be willing to run greater risks with inflation in order to ensure there is a sustained period of above trend growth. She has supporters in this strategy as well. Fed President Evans stated on Tuesday that it “wouldn’t be a crime” to overshoot the inflation target for a period and that an overshoot would be helpful in lifting inflation expectations.”

“Will Yellen repeat this message next week? The circumstances have changed dramatically. We now have a President who has spoken of a USD 1trn infrastructure spending program being coupled with the largest income and corporate tax cuts in history that would add as much as 25ppt to debt-to-GDP by 2026. What the Fed will no doubt take note of now is that the UST bond yield rise is coinciding with a sharp upturn in 5y/5y inflation expectations – the last notable time when 5y/5y inflation jumped at the same time as the 10yr UST bond yield was back in 2010 when there were hopes of reflation fuelled by the first round of QE after the Great Financial Crisis. That would imply that Trump expectations are doing the job.”

“Any signs from Yellen that the FOMC intends to pursue that strategy of an inflation overshoot would likely mean another lurch higher for long-term yields. However, the continued positive performance of the dollar would be much more questionable. Higher inflation in the US is only good for the US dollar if investors assume the Fed will deal with it. Any questions on that, would imply a potential fall in real yields that could see dollar buying quickly turn to dollar selling.”