Will the Washington drama divert the Fed?

Will the Washington drama divert the Fed?

27 May 2017, 08:49
Jiming Huang

Twice last year, the Fed delayed hikes due to political or market turmoil – once after a China-inspired decline in global equities, and again after the UK's Brexit vote. Amid a deepening US political crisis, investors seem to think US officials might be tempted to do so again. The market-implied probability of a June rate hike is now down to less than 80 percent, according to the CME, after being above 90 percent in March.

This time, however, we expect the Fed to be less sensitive to political developments. First, the fall in the dollar (down 6 percent from its peak) and yields (the 10-year yield is down 17 basis points in two months) could reassure the Fed that it has the headroom to raise rates without impacting the economy.

Second, about half of Fed officials were not assuming any Trump stimulus in their March forecasts in any case, so any political impasse shouldn't change their outlook. Finally, the metrics that the Fed is focused on, such as the jobless rate, have continued to move in favor of higher rates. Unemployment fell to 4.4 percent in April, below the 4.7 percent the Fed considers to be full employment.

We believe bond markets are now at risk of understating the pace of Fed tightening. We forecast US 2-year yields will hit 1.8 percent in six months, from 1.29 percent today, and we underweight high-quality government and corporate bonds in our global tactical asset allocation.

(By UBS)
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