The Federal Reserve followed script this week by raising interest rates, but added fuel to recent bond weakness and dollar strength with a more-hawkish-than-expected monetary policy forecast for 2017.
By the time the Federal Open Market Committee's (FOMC) decision rolled around Thursday, a rate hike was priced into markets. Implied probability of a 25 basis point increase was 100% and odds of a 50 basis point rise had even climbed to 10%. The only remaining question pertained to the Fed's dot plot. Long-term rate projections had been falling steadily since 2012, but a rise in inflation expectations following Donald Trump's election victory led to speculation about a faster pace of tightening. Indeed, the committee elected to increase its forecast from two hikes to three hikes in 2017, also raising its long-run rate to 3.2%.
When the Fed hiked the Fed Funds Rate last December, the market's reaction was muted. This time around, the fallout in bond and foreign exchange markets was much more significant. By the end of the day Thursday the Dollar Index had surged more than 1%, taking its gains in the last three quarters of 2016 to more than 9%. Yield on the 10-year U.S. treasury climbed another 15 basis points to 2.60% (where it closed Friday).
Early in the week, the dollar and bond yields were retreating after three U.S. central bankers--New York, Chicago and St. Louis Fed Presidents William Dudley, Charles Evans and James Bullard--expressed hesitancy about the pace of future rate hikes given uncertainty regarding the new administration's economic policies. However, Thursday's hawkish turn by the Fed--an aberration in post-crisis monetary policy--exacerbated recent post-election trends. Contributing to that sentiment was discussion about the eventual reduction in size of the Fed's balance sheet.
In the FOMC statement and post-decision press conference, Chairwoman Yellen took a victory lap on the strength of the U.S. economy. "It's important for households and businesses to understand that my colleagues and I have judged the course of the U.S. economy to be strong. We have a strong labor market and we have a resilient economy," she said.
While refusing to comment specifically on the president-elect's agenda, Yellen said the economy might not even need significant fiscal policy anymore to reach achieve full employment and the Fed's 2% inflation target. "There may be some additional slack in labor markets, but I would judge that the degree of slack has diminished. So I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment," she said.
Perhaps the only surprise in the market's post-decision reaction was the resilience of U.S. stocks. An exceptionally strong dollar poses two main risks to the American economy: 1) hurts exports and erodes profits for U.S. multinationals, and 2) Raises dollar-denominated funding costs worldwide, especially concerning for emerging markets. Only in 1999 and 1984 have we seen a persistently strong dollar and strong risk appetite harmoniously co-exist.
DoubleLine's Jeffrey Gundlach believes this is just the beginning of the sell-off in U.S. treasuries. In a webcast Tuesday on his firm's flagship Total Return Bond Fund, Gundlach said he believes 10-year yields will top 3% next year, which would "start to have a real impact on market liquidity in corporate bonds and junk bonds" and "bring into question some of the aspects of the stock market and of the housing market in particular." While his portfolio still has a shorter duration and less risk than the benchmark Barclays U.S. Aggregate Bond Index, Gundlach said he has started to increase the average duration of his holdings since July.
The Fed adjusted its policy outlook based on still-hypothetical future growth and inflation. In the first quarter of 2017 we'll get better indications about whether that decision was justified.
Italy's Caretaker Government Faces Decision On Bank Bailouts
Italy's beleaguered banks, under a caretaker government, continue to pursue last-gasp efforts to avoid state-sponsored bailouts.
Italian President Sergio Mattarella tapped Foreign Minister Paolo Gentiloni to take the reins as prime minister following Matteo Renzi's post-referendum resignation, with fresh elections on hold until the legislature adopts a new electoral law. The new government's most urgent priority is finding a solution to rescue the country's debt-laden banks.
On Tuesday, Unicredit, Italy's largest bank, unveiled its long-anticipated recapitalization plan. It will attempt to raise 13 billion euros while shedding 17.7 billion euros worth of bad loans (more than expected) and cutting an additional 6,500 jobs (bringing the total to 14,000). Investors liked the plan, with Unicredit stock rallying 16%, the most in six years (although it is still down 44% on the year). Fortress Investment Group and Pimco are taking majority stakes in the units buying the portfolio of non-performing loans. Unicredit also raised additional Tier 1 capital by announcing the sale of asset manager Pioneer to Amundi for 3.5 billion euros.
While analysts give Unicredit a reasonable chance of avoiding state aid, Monte Dei Paschi (MPS) is in much more dire straits. Europe's oldest bank insists it will plow ahead with a 5 billion euro private capital raise, which it must complete in the next two weeks after regulators rejected its request for an extension. MPS shares rallied 8% on the news, but observers remain highly pessimistic about a successful private rescue. Qatar Investment Authority, the anchor tenant of Monte Dei Paschi's equity offering, has refused to comment on its plans.
On Thursday, reports reemerged that Italian officials are preparing to inject public capital into MPS, in addition to other regional banks. The caretaker government has apparently drafted an emergency decree allowing for state aid as part of a so-called precautionary capital increase. An official announcement is expected next week.
If the Italian government can kick the can down the road with a rescue plan for its troubled banking system, it would provide an additional bullish input for resurgent global markets.
Strong Dollar Sends Chinese Assets Tumbling
China was among the biggest losers in the Federal Reserve's hawkish policy forecast.
Immediately following Thursday's announcement Chinese government bond futures fell to their daily loss limit (with 10-year government debt yield surging 22 basis points, the most on record) and the yuan testing eight year lows versus the dollar (to the key psychological of level of 7 CNY/USD). China's benchmark equity index finished the week down 3.5%. Dollar appreciation makes it more expensive for China to prop up the yuan and for companies to service their massive debt pile. The latest greenback rally could trigger additional capital outflows despite recent preventive measures.
Calls continue to grow louder for a large one-time renminbi devaluation, but the government is prioritizing economic stability ahead of next year's Communist Party Politburo. By some measures, their plan is working. In November, retail sales grew 10.8% and industrial production rose 6.2%, while for the first 11 months of the year fixed-asset investment climbed 8.3% (all greater than expected).
However, risks could also be rising as November brought a surprise increase in shadow banking activity. Shadow credit, the shifting of liabilities to more opaque securities like trust loans and bank-acceptance bills, skyrocketed to 479 billion yuan after having fallen to 55 billion in October. The People's Bank of China (PBoC) has promised better oversight of off-balance-sheet wealth management products, but again faces a dilemma between liberalization and stability.
Ironically (given the rhetoric of the U.S. president-elect), the yuan right now is the most expensive trade-weighted currency in the world. The centrally-planned economy has so far been able to avert a hard landing, but if the dollar continues to strengthen, Beijing could have to call an audible on its multi-decade economic playbook.