Comment: Fed minutes could set the market straight

By Ipek Ozkardeskaya

The Federal Reserve will release the May meeting minutes on Wednesday. Investors will be seeking further details regarding the possibility of an interest rate hike in June meeting and the Fed’s plans to start reducing the size of its balance sheet.

The activity on the US sovereign markets assesses 100% probability for a June interest rate hike since the FOMC’s latest policy meeting.

Inflation expectations are revised down, but June rate hike is still on the table.

The markets softened their hawkish stance regarding the Fed policies. The inflation expectations have been revised lower given Donald Trump’s inability to push his reforms through the Senate.

The political tensions involving the FBI investigations have not fully dampened the enthusiasm regarding Donald Trump’s massive spending plans and major tax reforms, but brought investors to re-price them further in time.

Fed has no reason to hold fire in June

Despite the turbulent political environment, the Fed is believed to be navigating with care through the storm triggered by Trump’s presidency. FOMC Chair Janet Yellen has been successful in avoiding a major squeeze in the financial markets by providing a correct dose of policy response to Trump’s colossal, and sometimes dreamlike, plans.

Happily for Janet Yellen, the solid US’ macroeconomic data has mostly justified the 50 basis points hike in the Fed funds rate over the three months following Mr. Trump’s election.

The latest labour data showed that the US unemployment rate fell to 4.4%, the lowest in a decade. The US stock markets rallied from record to record and the first quarter earnings season has been very encouraging and broadly justified the Trump-reflation rally in the stock markets.

Although the US recorded a softer than expected GDP growth in the first quarter of 2017, the weakness has been described as temporary by the Fed members.

At this point in time, there is no fundamental reason to hold the Fed members back from a June interest rate hike.

Latest comments from the Fed members hint at no particular resistance to a June rate hike and this is what investors want to read through the Wednesday’s minutes.

Balance sheet normalisation should have a minor impact.

The Fed’s plans to start shrinking the size of its balance sheet has first boosted the Fed hawks and translated into a stronger US dollar. Yet, the impact of the portfolio normalisation is being priced out due to the light impact it would have on the balance sheet. In fact, many analysts warn that the impact would not exceed 25 basis points.

The US dollar index at six-month lows

The US dollar index retreated to levels prior to Donald Trump’s election. To us, the pullback in the US dollar could be overdone, provided that the Fed has increased interest rates by 50 basis points and is expected to proceed with an additional 50 basis point hike before the end of 2017.

A dovish shift in fiscal policy expectations could take off some pressure off the Fed’s shoulders, yet the Fed’s position relative to its G10 peers remains comfortably hawkish, giving the US dollar a reasonable base to correct its recent weakness.

Author Ipek Ozkardeskaya is a market analyst at London Capital Group