Fed Still Committed to Hike
The Fed's new forecasts show a third rate hike in 2017 for the second half of the year and three more in 2018.
As expected, the US Federal Reserve raised the target range for the policy rate by 25 basis points to 1.00 percent – 1.25 percent. It also updated its policy normalization principles with specifics on how it intends to end reinvesting maturing assets on its balance sheet. The Fed's new forecasts show a third rate hike in 2017 for the second half of the year and three more in 2018. An announcement on balance sheet policy changes could come as soon as the September meeting, which would likely delay the next rate hike to December.
Fixed Income: Environment Might Remain Favorable
With the Fed signaling its willingness to hike again later this year and in a similar fashion the following years, we expect real yields particularly at the belly of the US Treasury curve (i.e. 5-year segment) to reprice more significantly given its high correlation to the Fed Funds rate and the large gap between current market expectations and the Fed's own projections. Initial market reaction supports this view, which was also visible in longer real yields. After a dovish European Central Bank (ECB) last week, the current environment might remain favorable for fixed income assets until signs of a bottoming in inflation momentum become visible. Still, given the concrete Fed plans to change its reinvestment policy, contrasting with an ECB reiterating its commitment to quantitative easing measures, we continue to expect US Treasuries to underperform global government bonds.
Steeper Yield Curve Would Help Financial Equities
Recently, defensive sectors have benefited from the decline in inflation and move lower in yields. Although this could continue in the short term, we still expect a steepening of the yield curve in the USA. In this scenario, defensive sectors would likely come under pressure – an outcome that we express with our cautious expectations on consumer staples – and financials would likely be the main beneficiaries of a steeper yield curve. An increase in long-term yields would help financials' profitability, both for banks and insurance. However, considering the risk to this scenario in the short term, we remain neutral in financials and would prefer to focus on sectors offering both exposure to yields and growth, such as healthcare and real estate. For broader equities, as long as the growth picture remains healthy, higher yields should not be a major issue at those levels. However, a combination of higher yields and slowing growth momentum could trigger worries for equities, as it would mark an end to the perfect setup of low yields/strong growth momentum that has fueled the rally in equities year-to-date.
Steady Fed Tightening Supports US Dollar
The US Dollar re-strengthened on the Fed announcement after it had previously come under renewed pressure from softer than-expected US inflation data for May. The Fed's essentially unaltered forward guidance implies further steady tightening but bond futures markets continue to show doubts, with odds for a September hike dropping after the announcement. A lot will depend on upcoming US economic data. If it moderately rebounds as we expect, the market's rather flat interest rate expectations have room to drift higher. In combination with a cautious European Central Bank amid subdued Eurozone inflation this should help to re-widen the US yield advantage in support of the US Dollar.