Julius Baer Research | In the six weeks since the last Federal Reserve (Fed) meeting, the world has been shaken by several events. Despite rallying equity markets, investors stay rattled and filled with unease. Yet in the US, news on the economic front has been mainly positive. Indicators such as the June employment report, retail sales, housing starts, capacity utilization and the service industry have all beaten expectations. Latest Markit manufacturing purchasing managers’ indices (PMI) readings continued to improve in July as did the Institute for Supply Management (ISM) readings for June, which showed a considerably strong new order component. Citi Surprise Index has been turning positive after remaining in negative territory ever since January 2015. Last but not least, the Fed’s own assessment, i.e. the Beige Book, suggests a positive outlook. Against this backdrop, the Fed statement this week is going to be considerably more upbeat.
Markets have massively brought rate-hike expectations forward, shifting from Feb 2018 to now Feb 2017 in the last four weeks. With the Fed median forecast from the dot plot suggesting two hikes in 2016, however, they still may be too complacent about the Fed’s expected rate path. This week’s Fed statement will start to prepare for the possibility. As the meeting is not associated with a Summary of Economic Projections or a press conference by the chair Janet Yellen, more hawkish rhetoric may be expected in speeches held by Fed members in the weeks to come. The adjustment of this gap between market expectation and Fed determination could cause some distress on financial markets, while we believe that the US dollar bull should continue. Despite a more hawkish Fed we expect the Fed’s next rate hike will happen only in 2017. As the USD rises, financial conditions tighten, which undermines the Fed’s ability to hike rates.