In line with expectations, yesterday the Fed hiked the target rate by 25bp to 0.50-0.75%. Focus quickly shifted to the updated dots, where the median dot for next year was revised up to three hikes from two hikes previously, while the median dot for 2018 was unchanged at three hikes.
Fed Chair Janet Yellen also sounded more hawkish in the press conference than previously as she abandoned the case for running a high pressure economy and indicated that the Fed has not fully taken Trump’s fiscal plans into account, which could result in further Fed hikes than currently indicated.
We stick to our view that the Fed will hike twice next year (June and December). However, we now consider the risk skewed towards three hikes. That said, it has to be remembered that the Fed will turn more dovish next year due to shifting voting rights.
The market reaction over the next couple of days and weeks will very much hang on how risk appetite reacts to the Fed decision. Looking ahead, we still see the US curve flattening further and especially 5Y and 10Y yields moving higher as the market slowly prices in more hikes. We keep the view that 10Y US Treasury yields will move towards 3.0% in 2017. However, the way ahead will be bumpy. The curve is already quite steep and the Fed rotation indicates a more dovish Fed next year. Remember, despite the dots, Fed policy is still data dependent. In respect of Europe, the impact from higher US yields can be felt mainly from 5Y and beyond. The ECB still has a firm grip on the short end, especially as core inflation is expected to stay very low throughout 2017. In that respect, note the 2Y Schatz fell to a record-low of -0.77% as the new collateral measures from the ECB/Bundesbank have done little to ease the repo squeeze.
The USD strengthened broadly, which was as expected given the surprisingly hawkish shift by the Fed, expecting three hikes in 2017. In particular, the JPY weakened sharply driven by its historical high negative correlation with US rates. EUR/USD also dropped but at the time of writing has stayed within the recent 1.05-1.09 range. Strategically, we believe the USD will strengthen broadly near term supported by rising US growth and rate expectations particularly versus rates-sensitive currencies such as the JPY. We continue to see EUR/USD as a sell-on-rallies where we are likely to see a test and break of the 1.05 level near term.
We forecast EUR/USD at 1.05 in 1M and 1.04 in 3M. Longer term, we continue to expect EUR/USD to edge higher towards 1.08 in 6M and 1.12 in 12M on valuation and the record large eurozone-US current account differential.
Commentaries, trading setups and many more are provided by FxWatcher. Try out FxWatcher service for 5 days for free!
EUR/GBP has remained fairly stable close to the 0.84 level over the past week. We expect the MPC to vote unanimously in favour of keeping the Bank Rate unchanged and a status quo with regard to the asset purchase programme at the Bank of England (BoE) meeting today – in line with market pricing. We do not expect the MPC to change its current rhetoric on inflation risks and in general, we do not think that data published since the November MPC meeting warrants a change in communication by the MPC.
While the BoE at the last meeting shifted from an easing bias to a neutral bias due to a combination of the weaker GBP and resilient economic data, we do not believe BoE will hike rates during a time of elevated political uncertainty. In this respect, the current market pricing, with one full hike priced in by year-end 2018 and a total of two by year-end 2019, is overdone, in our view. On the other hand, the triggers for further easing are substantially slower growth and/or higher unemployment, which is also not our base case.
We still expect the GBP to come under renewed pressure in the run-up to when Article 50 is triggered, and we would consider buying EUR/GBP on potential dips towards the 0.83 level for a move higher in coming months, driven by renewed political uncertainty.
