Can the Fed maintain its credibility?

Market expectations for the Fed’s interest rate trajectory are now in line with the central bank’s ‘dot plot’, after being in sharp divergence in recent years. With the market pricing in an FOMC rate hike with almost certainty, the Fed’s credibility is on the line. Can the Fed maintain its credibility?

While we think that its third rate hike in the current cycle is long overdue, the stark change in rhetoric from Fed officials is surprising. Market pricing of a potential rate hike at next week’s FOMC meeting moved from 30% to over 90% in just three days after several hawkish speeches from Fed Board members, including Chair Yellen and Vice Chair Fischer. The real concern, however, that the Fed should have is the loss of credibility if it does not act after its hawkish commentary.

We remain unconvinced about the Fed’s voracity to hike rates aggressively as required as it has talked tough before and then not acted. Indeed, three rate hikes is only in line with market expectations and the Fed is only now regaining credibility, according to the Overnight Indexed Swap (OIS) market.

Although the US economic recovery remains robust, with the jobless rate now below pre-crisis levels, there are some indications that suggest that the Fed may not reach the three expected rate hikes. There is significant political uncertainty in Europe, which was a concern for the Fed in 2016 after the EU Referendum in the UK, and the US Dollar remains strong –another concern for the Fed in recent years. Meanwhile, the Bloomberg Financial Conditions Index shows that financial conditions in the US have tightened to the highest level in over two years.

Meanwhile, the anticipated USD strength after Fed commentary has not transpired. We feel that the risk is skewed to the downside for the dollar if/when the Fed hikes rates in March given recent moves and elevated investor positioning. We expect the USD to rebound if the Fed become more proactive and raise rates more quickly-than-anticipated in H2 2017.

Martin Arnold, Global FX & Commodity Strategist at ETF Securities

Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.