Comment: Focus on 'dot plot' as Fed prepares to hike rates

By Ipek Ozkardeskaya, London Capital Group

The Federal Market Open Committee (FOMC) will hold a two-day meeting on Tuesday and Wednesday. The FOMC is expected to raise the target for the Fed funds rate by 25 basis points to 0.75%-1.00% and deliver a fairly hawkish accompanying statement.

Based on activity in the US sovereign bond market, the probability of the Federal Reserve (Fed) hiking rates is priced in at 100%.

That follows a significant shift in the odds for Fed rate normalization since the beginning of the year.

America's Federal Reserve was expected to raise rates by three times at the beginning of 2017. Donald Trump’s victory and his new administration’s expansive fiscal plans have been the main catalyzer for the Fed’s shift towards orthodoxy.

Despite those now higher odds for Fed tightening, at the beginning of March investors were assigning a less than 50% probability to a Fed hike at its mid-month meeting. Many believed that June could be a better option as it would give the Fed time to get more clarity on the new administration's intentions regarding fiscal policy.

However, at her semi-annual testimony, FOMC Chair Janet Yellen made clear that the Fed would not base its monetary policy on speculative market pricing about Donald Trump’s spending plans nor would she wait for Trump’s administration to announce a clear policy agenda to act.

All Janet Yellen needed was markets’ expectations apropos the major economic variables to adjust monetary policy.

In fact, inflation expectations rose significantly since November 2016. Donald Trump’s plans to spend a billion dollars on infrastructure, lower corporate taxes and fight his best to keep jobs in the US revived inflation expectations in the US and across the globe.

As a result, the US sovereign yield curve also shifted notably higher. Benchmark 10-year US Treasury yields took off from below 1.80% at the beginning of November 2016 to trade above 2.60% last week.

Wall Street also recorded an unprecedented rally to celebrate the end of the zero-rate, zero-inflation environment.

US capital markets' reflation rally spread worldwide, with the US dollar index appreciating more than 5% over the same period. Commodity prices surged alongside.

Meanwhile, in the world’s biggest factory, China’s producer prices hit an eight-and-a-half-year high of 7.8% in February.

The world has stepped into a new era of reflation.

Steeper normalization in US rates, stronger US dollar

The so-called ‘dot plot’ is the main focus of this week; Fed members’ projections vis-à-vis the future of the US’ monetary policy could indicate whether or not expectations of a steeper policy path are justified.

In the current context, the Fed could further increase the pace of its interest rate normalization and raise rates four times, instead of three. Up to 100 basis points of tightening are expected by the end of 2017 to prevent an eventual overheating of the economy due to the Trump effect.

By Ipek Ozkardeskaya, London Capital Group