FOMC preview Fed set to keep door open for a June hike

Investment Research General Market Conditions 14 March 2016 FOMC preview Fed set to keep door open for a June hike We expect the Fed to keep the Fed funds target rate unchanged at 0.25-0.50% at this week s FOMC meeting (announcement due Wednesday 19:00 CET). As this is widely expected, focus should quickly shift towards the updated projections for the Fed funds target rate (the so-called dots ). We expect the Fed to signal two or three hikes this year (down from four) and four hikes next year (unchanged). The Fed wants to keep the door open for a June hike. Our main scenario is that the Fed will stay on hold until September but the probability of a move in June and that the Fed will tighten monetary policy more than once in 2016 has increased due to the rebound in risk sentiment, continued improvement in the labour market and higher PCE core inflation. Financial stress has eased since the last meeting in January Source: Macrobond Financial Markets have repriced the Fed and now expect two and half hikes by December 2017. Fed to signal two-three hikes this year We expect the Fed to keep the Fed funds target rate unchanged at 0.25-0.50% at this week s FOMC meeting. As this is widely expected among analysts and market participants, focus should quickly shift towards the updated projections and, in particular, on the FOMC members projections for the Fed funds target rate (the so-called dots ). If the Fed stays on hold as expected, this would in itself lead to a lower median dot this year of 25bp. In our view, this would signal that most FOMC members think that the rough start of the year has merely been a bump in the road. However, just two of the seven members projecting four hikes in December have to lower their individual dots more than 25bp before the median dot for 2016 would signal two hikes (from four in the December projections). This would signal that most FOMC members have become less optimistic on the outlook, which warrants that the Fed should carry on more cautiously. Overall, however, given that the labour market continues to perform well, PCE core inflation has been higher than expected in recent months and as we have seen a rebound in risk sentiment, we think that the Fed will keep the door open for a hike in June. That being said, it is important to remember that all FOMC members, also non-voting members, are making projections and since we assess that most voting members are dovish-to-neutral, we think the median dot has a built-in hawkish bias and, in reality, the median dot among voting members is probably lower than the overall median dot. In other words, if the overall median dot for this year signals three hikes, it is not unlikely that the median dot among the voting members is two hikes. We expect the median dot for 2017 to be unchanged, signalling four hikes. Based on recent Fed communications, it seems as though the Fed s analysis of the US economy is more or less unchanged: it still expects the economy to grow above trend in coming years and that inflation should move towards 2%, especially if the dollar and oil price stabilise. Just one FOMC member has to lower his/her estimate for the long-term Fed funds target rate before the long-term dot is lowered from the current 3.50% to 3.25%. If two FOMC members currently signalling four hikes lower their individual dots more than 25bp, the median dot for 2016 would signal two hikes 4.00 % 3.50 3.00 2.50 2.00 1.50 1.00 0.50 Source: Federal Reserve PCE core inflation has begun to pick up Analyst Mikael Olai Milhøj +45 45 12 76 07 milh@danskebank.dk 'dots' from December projections The ninth 'dot' determines the median 'dot' 2016 2017 Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com

In the January FOMC statement, the Fed removed the phrase risks to the outlook for both economic activity and the labour market as balanced. As data has been improving and the labour market has continued to perform well, we think the Fed will state that risks are nearly balanced. This would be another sign that the Fed wants to prepare markets for further tightening this year. Inflation prints have been higher than expected but low inflation expectations still a concern The projections for PCE core inflation could be interesting as the inflation prints have surprised on the upside in recent months. In January, PCE core inflation was 1.7%, which is only 0.3pp below the Fed s 2% target. This is already higher than the median expectation based on the December projections, which was 1.6% y/y in Q4. Thus, it is not unlikely that the projections for inflation will be revised up. On the other hand, surveybased inflation expectations have declined overall since the January FOMC meeting and wage inflation is still subdued. In our view, this suggests that the Fed will continue to sound cautious on the inflation outlook. In the FOMC statement from the January meeting, the Fed removed the wording that it was reasonably confident that inflation would move towards 2%. The question is whether the Fed will reinstate this given the higher-than-expected inflation prints. Fed in a difficult position but likely to be more hawkish Overall, the Fed still finds itself in a difficult position. On the one hand, the labour market continues to perform well. On the other hand, the economy still looks a bit shaky with some key economic figures such as the ISM indices still being on the weaker side and with markets still being somewhat anxious despite the recovery over the past couple of weeks. In our view, the Fed is nervous to tighten too much, too quickly and, historically, it has taken the situation in the financial markets into account when setting monetary policy. However, we think the higher-than-expected core inflation prints and continued improvement in the labour market explain why the Fed will probably use the meeting to prepare the markets for further tightening. Our main scenario is that the Fed will stay on hold until September and only tighten monetary policy once in 2016. However, the probability of a move already in June and that the Fed will tighten monetary policy more than once this year has increased due to the rebound in risk sentiment, continued improvement in the labour market and the accelerating PCE core inflation. Markets have repriced Fed and now expect two and half hikes by year-end 2017. The next hike is fully priced in for November this year and markets place a 66% probability of a hike in June. This suggests that it will take a relatively hawkish Fed on Wednesday to push short-end rates higher. If the median dot for this year signals three hikes and Fed Chair Janet Yellen downplays the drop in surveybased inflation expectations at the press conference, we believe this would be enough to send US yields higher following the meeting. If the median dot for this year signals only two hikes this year, we believe the market reaction will be limited. PCE core inflation only 0.3pp below Fed s 2% target Inflation expectations still low Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Markets Indicators as the ISM indices are still to the weaker side Source: ISM Markets have repriced the Fed We expect the Fed to send a hawkish signal 2.50 2.00 1.50 % Fedfunds rate Expected median 'dots' Danske Bank expectations Market expectations 1.00 0.50 0.00 2016 2017 Source: Bloomberg, Danske Bank Markets Source: Federal Reserve, Danske Bank Markets 2 14 March 2016 www.danskeresearch.com

FOMC chart book Employment growth continues at a solid pace Unemployment rate slightly below NAIRU Wage inflation is trending up but still subdued Fed sees the world through the Phillips curve PCE core inflation has picked up in recent months Unit labour costs indicate higher inflation Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Markets Fed concerned about low inflation expectations Oil prices have rebounded slightly Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Markets Source: EIA 3 14 March 2016 www.danskeresearch.com

Rebound in financial markets USD has stabilised but still relatively strong Source: Macrobond Financial Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Markets Still large credit spreads Financial conditions have eased recently Source: Bloomberg Source: Goldman Sachs, Federal Reserve, Danske Bank Markets Historically, the Fed has not increased the target range when the weighted ISM index is at the current level Private consumption main growth driver Note: Dark (light) shading indicates periods of tightening (easing) Source: ISM, Danske Bank Markets 4 14 March 2016 www.danskeresearch.com

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