If we look at the data it shows US economy is making a good progress and expanding slowly and steadily. Housing sector has improved. On business parameters, things look decent if not great. But recent export figures shows 1.8% decline on month on month basis (reference Oct’16). Strong dollar? hmm! The recent employment figures were strong and suggested improvement i.e. ongoing job gains and declining unemployment rate which is 4.6% (lowest level since August 2007). Inflation firming up and still within FOMC’s longer run objective of 2%.
So, overall it’s a done deal for Federal Reserve (FED) and Yellen aunty has got most of the boxes ticked to hike the rates into a range of 0.5-0.75%.
But….let’s look at the counter arguments on a rate hike.
On one hand tightening into economic strength looks good and is advisable, but should FOMC hike rates when the S&P500 valuations are high and above 5 & 10-year average?
Wont a rate hike make a strong Dollar even stronger and thereby make exports even more expensive? A strong dollar is not good for American businesses such as Apple, Nike etc. that sell their products abroad. A stronger dollar will make them even more expensive. A 5-6% increase in Dollar puts a pressure of around 3% in EPS of S&P500.
Now let’s look at this event from a political point of view.
Trump is still to take over. Nobody knows what’s in the pipeline. Till his rhetoric become concrete actions, nobody knows clearly what will happen. The markets have reacted as if he has already rolled out a huge fiscal spending program. Let the plan get structured and get past Congress. How many weeks or months will it take? No one knows! The Fed does not know yet what will happen when Trump will take office next year. So shouldn’t FOMC wait for another quarter to see how his policies shape up?
Also, inflation is already rising and reaching 2% which is what FED wants and is comfortable with. If hike happens, inflation may rise further which may put FED under pressure. They want it to rise but within their comfort zone which is definitely not 4-5%.
So to cut the story short, though I have given counter arguments and I am against a rate hike at this stage, it looks more or less certain that FOMC will hike. Even the current market moves/data since last 1 week or so seems to have discounted this possibility.
So what will happen to Dollar then?
If FOMC understands the above arguments against a hike at this point of time and doesn’t hike OR even if it hikes into a range of 0.5-0.75% with unclear guidance/timetable on further hikes for next year (especially in first half of 2017) and says its data dependent, expect the Dollar to correct by 3-4%.
I will be more than surprised if Yellen aunty hikes and at the same time comes up with a clear guidance of how and when the next hike will come. In that case expect the dollar to shoot up!
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