Today the dollar continued its rally along with US equity indices whilst 10-year Treasury yields rose 5 basis points. The DXY Index is now up more than 1.4% so far this week; at 93.4 at time of writing, it is now back to where it was this time last month. Some of this may be due to profit taking from the recent rally in the euro (which is still up around 12% versus the US dollar year to date). The rest of the dollar rally and sell-off in Treasuries stems from hawkish comments from Fed Chair Yellen (and New York Fed President William Dudley) as well as market optimism over the anticipated tax proposal from President Trump later today.
In her speech yesterday at the National Association for Business Economics, Janet Yellen expressed support for further gradual raising of rates - increasing December hike expectations to 70%. Treasury yields rose across the curve but the shorter end continues to perform weaker relative to historic data and 2-year yields at 1.48% are at their highest since 2008 (modified duration is only an equal measure of risk under a level shift in the yield curve which is not the scenario we have been facing over recent years). Part of the reason for longer maturity yields being less vulnerable and less volatile of late is the transient nature of any growth stimulus coming from (potential) tax reforms and such like. Indeed the Longer Term Implied Fed Funds Target Rate (extrapolated from the Fed Dots plot) at 2.75% is now at its lowest ever with five voting members estimating that the long-term target rate is now 2.5% or below. Indeed only 1 of 14 member now believes the longer term target is above 3%, a far cry from even 2 years ago when only 1 member was gloomy enough to vote as low as 3% and the median was 3.5% (0.75% higher than present).
In considering all recent commentary from the Fed it's worth remembering that the higher likelihood of a December rate hike isn’t quite as ‘data dependant’ as it has been in the past. Yellen’s comments and FOMC meeting minutes convey a desire to continue with a gradual path of rate rises DESPITE downward revisions to projections of inflation and the neutral rate.
Yellen’s comments on inflation included: ‘downward pressures on inflation could prove to be unexpectedly persistent’, ‘inflation expectations will remain reasonably well anchored’, ‘inflation has been unexpectedly weak from the model's perspective’, ‘this year's low inflation is probably temporary’. Surmising labour and inflation outlooks she stated, ‘I view the data we have in hand as suggesting a generally healthy labor market, not one in which substantial slack remains or one that is overheated.’ and ‘the notable decline in inflation compensation may be a sign that longer-term inflation expectations have slipped recently.’
Taking this tempered outlook for inflation the possibility of an imminent rate hike should in fact help create stability and confidence in markets. We also expect Trump’s lauded tax reforms will be vastly diluted if not stagnant. He will struggle to get enough support for such unfunded tax cuts, especially with the original healthcare reform bill all but dead in the Senate: now refusing to vote on it. But the markets love such narratives as an outlet for temporary optimism; we, however, don’t yet think there is sufficient evidence yet to fully price in such unlikely growth stimuli into our forecasts.