Originally published by AMP Capital
As widely expected the US Federal Reserve raised the key Fed Funds rate by another 0.25% for the sixth time since starting to hike in December 2015. This takes the Fed Funds rate to a range of 1.5% to 1.75%.
Supporting this the Fed was more upbeat on the economic outlook noting that “the economic outlook has strengthened” and that inflation is expected to move up “in coming months” and at the same time Fed Governors and Presidents raised their expectations for growth and inflation and lowered their expectations for unemployment.
While the median expectation of Fed officials remained for three rate hikes this year (ie the so-called “dot plot”), it now only requires one extra official to move to four hikes for the median to become four. What’s more the profile for Fed interest rate expectations moved higher relative to that seen in December. See the next chart.
While Fed Chair Powell indicated that the inflation target is symmetric suggesting a degree of tolerance for an upside overshoot on inflation along with uncertainty about the Phillips curve relationship, overall his comments and the Fed statement are consistent with the Fed becoming a bit more hawkish. Our assessment remains that the Fed will hike four times this year and that the dot plot will move up to that in June. The Fed is continuing to raise rates “gradually” but its just becoming a bit less gradual.
The market reaction to the Fed’s announcement was a bit messy with long term bond yields little changed (suggesting no surprise), the US share market down slightly (suggesting a concern the Fed may be becoming more hawkish although talk that Trump will soon announce tariffs on China probably impacted here too) and the US dollar fell (suggesting that currency markets expected an even more hawkish Fed and so traders had to unwind more hawkish bets).
Overall our assessment is that ongoing US monetary tightening will put more upwards pressure on bond yields (and hence is negative for bond returns), but because US monetary policy is still a long way from being tight it won’t yet threaten the strong US growth outlook or the ongoing rising trend in share markets. That said, the uncertainty around US inflation and interest will be a continuing source of volatility in share markets and serve to constrain returns this year.
For Australia, the Fed’s latest hike really just reflects that US growth is strong and this is good for Australia. Rising US bond yields may at some point put some upwards pressure on local bank funding costs but at present this is being offset by competitive pressures amongst the banks and so recently some mortgage rates have fallen. And the RBA is a long way from following the Fed higher in terms of interest rates because there is still a lot of spare capacity in the Australian labour market compared to the US. In fact labour market underutilisation rose slightly in Australia in February to 13.9%. See the next chart. We don’t expect the RBA to start raising rates until early next year.
With the Fed’s latest hike, Australian official interest rates have now fallen below those in the US for the first time since the early 2000s. Historically, a low and falling interest rate differential relative to the US has seen the Australian dollar fall. While a broadly weaker US dollar and solid commodity prices have prevented this over the last two years ultimately we expect the Australian dollar to fall, particularly as US rates continue to rise further above Australian rates. However, strong commodity prices should prevent a fall to $US0.48 as occurred in 2001 which was the last time Australian rates were below US rates!
