The Fed has just completed the third hike in their ‘gradual’ tightening cycle and are still forecasting another two hikes in 2017. The likelihood of a March hike was below 50% just a few weeks ago, but the FOMC members embarked on a full-blown communications offensive and managed to convince the vast majority of market participants, driving expectations to near 100%.
What is even more interesting, is that they actually appear to have convinced the market of two more hikes in 2017: Fed Fund futures now imply a 60% chance of further hikes in June and December. FOMC members have never voted to hike rates when expectations were below 70%, so there is still a little doubt in the market, but Fed forecasts appear to be carrying a lot more weight in 2017.
Fed forecasts were not a successful strategy in 2016: after an initial hike in Dec 2015, the committee’s resolve quickly evaporated, as they were faced with panic and market turmoil on every front. Oil had been declining steadily since mid-2014, and the continued dollar strength following the Fed’s decision reinforced this trend, helping to send US Crude Futures below the GFC lows, to levels not seen since start of the second Iraq war in 2004.
This continued dollar strength caught some participants off guard – the ‘dovish’ hike was completely priced in and they were expecting a ‘sell the news’ reaction. Many others, less prone to over-reliance on idioms, saw it coming: a predictable effect of market wide portfolio adjustment on the back of the long-awaited shift in policy.
Capital had been fleeing China at a rapidly expanding pace since 2014 and this phenomenon was, once again, reinforced by the persistent dollar strength and causing quite a stir in markets. The S&P 500 index was already carving a top months prior to the 2015 hike decision and lost 80 points over the next two days.
Santa came to the rescue briefly, but the Christmas cheer failed to last the year: a false bullish break on the 29th preceded a 280 point decline, beginning on the last trading day of 2015, and lasting until February 12, 2016.
The sky was falling. Add Brexit jitters to this already poisonous mix (and an eventual Brexit) and is it any wonder the Fed played it careful in 2016? Despite the loss of credibility, they did the right thing – nothing.
So What’s Changed?
Though US Oil Futures have pulled back over the past couple of weeks, they rallied more than 100% in the year to January 1st, 2017, and remain supported by an ascending channel with a 23.6 Fibonacci confluence. Despite persistent disappointments throughout 2016, markets were astonishingly tolerant.
OPEC members eventually agreed to act in their own interests in November, even managing to get non-OPEC nations on board in early December. Whether or not individual states have stuck to the agreed cuts is a matter for debate, and there are rumours cuts are unlikely to be extended.
But either way, OPEC jawboning throughout 2016 and the long-awaited agreements seem to have done the job for the time being: oil remains supported, well above the 2016 crisis lows.
Trump and His China Obsession
Capital flows out of China are still an issue, but no one seems half as worried as they were in 2016. China is working hard to ebb the flows and will continue implementing new capital controls – Donald Trump is right about currency manipulation.
However, he seems to have gotten it backwards (or perhaps he’s gotten China mixed up with Japan?). The dollar/yuan opened the month at 6.849, down from a high of 6.986 at the end of 2016. The pair is still trending up and will likely continue to do so over the next year, but momentum appears to have subsided for the moment.
Predictions Coming True
The Brexit vote has come and gone, and the world is still standing. People have been quick to criticise the remain camp for their ‘scare campaign’ and the BoE for cutting rates in the aftermath. Their main predictions, however, have come true: the pound did crash (and well before the BoE cut), and inflation is on the rise and may well overshoot the central bank’s target.
The fears regarding London’s commercial property market seem to have subsided, though one is starting to see some worrying signs in the residential market, especially in the outer suburbs of London.
On the other hand, one could well argue that this is nothing but a healthy correction. Q4 GDP was quite strong, largely on the back of a pickup in net exports (thanks to the precipitous fall in the pound). It is very hard to say what this picture would have looked like, had the BoE not eased following Brexit. It is also worth noting that Brexit hasn’t actually happened yet!
Back to the S&P 500
Brexit and Trump gave the index a few hiccups along the way, but it always came back within a few sessions and proceeded to trade to new all-time highs. The benchmark actually appears to have picked up momentum, trending up at an angle that makes the prior rally look like child’s play.
Long story short, none of the risk themes from 2016 has disappeared entirely, but the danger seems to have retreated a little for now. The start of 2016 featured a distinct air of panic and fear, completely alien to those of us who started our careers in the QE age.
The Key Numbers
Things were actually looking really scary for a while there. Wage growth has not yet recovered from the recessionary effects of GFC and we were potentially on the brink of another crisis. Yellen and the other FOMC members did the right thing when they played 2016 cautiously and eventually hiked in December, repairing their somewhat damaged credibility.
The December hike passed essentially unnoticed: oil held up, the yuan stayed down and the S&P 500 did what it does best. Trump did not drain the swamp, he hired guys from Goldman Sachs. Brexit killed the pound, but it gave life to the FTSE. When all’s said and done, sentiment is in pretty good shape: no one is screaming buy (except CNBC), and no one is screaming sell (except the same guys who have been wrong for the past decade). Markets are complacent.
The Fed capitalised on this complacency last week, hiking rates by a further 25 basis points and equity markets have once again come out unscathed. The dollar even sold off. Janet must be laughing.
Excluding a return of the euro crisis in one of its various forms (Grexit, Frexit etc), it seems extremely likely one will see two more hikes in 2017, as the Fed seeks to return rates to some form of normal. That way, if the death bells do start tolling again, the Fed will at least have some ammunition up their sleeves. …
And hey, if that does not work, there is always QE5 and they still have not tried helicopter money.