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Investors Should Revise their Liftoff Expectations as FOMC Remains on Track to Raise Rates this Year

On Friday, San Francisco Fed President Williams (dove, FOMC voter) and Cleveland Fed President Mester (moderate, FOMC non-voter) both said they expect the FOMC to begin liftoff at some point later this year.

 

According to CNBC, San Francisco Federal Reserve President John Williams believes the U.S. central bank should raise rates twice this year if economic data meet expectations. In the meantime, according to WSJ, Federal Reserve Bank of Cleveland President Loretta Mester said raising rates right now wouldn’t be a problem for the economy as a whole.

 

These two statements confirm that most of FOMC members seem ready to raise rates this year. The fact is that the median dot plot for 2015 remained at 0.625% during the June FOMC meeting. It suggests that the committee expects at least two hike in 2015 despite that the World Bank joined the IMF in urging the Federal Reserve to hold off raising rates until 2016.

 

As suggested by the chart below, the gap between investors’ expectations and FOMC projections remains huge. But if data keeps on improving in coming weeks and Grexit is avoided, investors should revise upward their expectations concerning the pace with which the FOMC will tighten its policy.

 

 

 

The USD Will Pursue its Rally as Investors Underestimate the Pace with which the Fed Will Tighten its Policy

According to the Bloomberg, on January 30, Federal Reserve Bank of St. Louis President James Bullard said investors are wrong to expect the Fed to postpone an interest-rate increase beyond midyear, with the U.S. economy leading global growth and unemployment dropping and noted that:

 

The market has a more dovish view of what the Fed is going to do than the Fed itself…
… Markets should take it at face value from the Fed’s rate projections

 

In this context, I decided to take a look at both Fed fund futures and latest FOMC median forecasts (December) and the fact is that the gap between investor’s expectations and Fed guidance is simply HUGE. As a matter of fact, Fed officials expect the benchmark funds rate rise to 1.125% by the end of 2015 while investors are only betting on 0.410%.

 

 

Of course, Fed’s forecasts seem to be too agressive as they imply four rate hikes for 2015 in a context of 1) CPI’s weakness, 2) global slowdown and 3) geopolitical tensions, but a liftoff by midyear remains the base case scenario. Separately, according to Fed funds futures, investors see only a 15% chance that the Fed will raise its benchmark rate in June.

 

As a consequence, this situation implies that there is still a huge potential of appreciation concerning the USD especially as:

1) ECB will implement QE next month.

2) SNB has an unofficial corridor of CHF1.05-CHF1.10 against €.

3) BOJ will keep on implementing an accommodative monetary policy.