Investors are gearing up for Wednesday’s interest rate decision from the U.S. Federal Reserve with a majority of Fed watchers in the market believing that a rate hike is likely to occur.
According to the CME’s Fed Watcher tool, the probability of a looming rate hike of 0.25 basis points at the conclusion of the Fed’s 2 day December policy meeting on Wednesday currently stands at 94.9 percent.
Fed Chair Janet Yellen testified before a Congressional committee in mid November and spoke about the appropriateness of a rate hike occurring “relatively soon” which suggests that a December rate hike shouldn’t come as a major surprise.
Investors will also pay close attention to the Fed’s updated economic projections and plot chart forecasting further rate hikes in 2017 at the end of their December policy meeting and listen to descriptions about the economy from Fed Chairwomen Janet Yellen during her follow up press conference.
Over the past several months, positive signs have emerged about the health of the U.S. economy as measured by inflation, U.S. jobs, GDP, and a recovering housing market.
One of the main drivers that held back inflation at the beginning of 2016 was tumbling crude oil and commodity prices.
In recent weeks, crude oil prices have rebounded sharply through a coordinated effort among OPEC members at their November 30th meeting in Vienna to bring forward an oil production cut of 1.2 million barrels a day, led by Saudi Arabia’s cut of 486,000 barrels a day and followed by UAE’s reduction of 139,000 barrels a day beginning in January.
On Saturday, non-OPEC members, led by Russia agreed to cut production by 558,000 barrels a day.
Russia is committed to reducing 300,000 barrels a day beginning in January.
Crude oil prices rose over 4 percent on Monday on the news.
ICE Brent Crude (Feb. 17′ Futures) is currently up 4.42 percent or $2.40 to $56.73 a barrel while WTI (January 17′ Futures) is trading up 4.97 percent or $2.56 to $54.06.
Rising crude oil and commodity prices help inflation to rise.
Strong Fundamentals For Rate Hike
The Fed’s preferred inflation gauge, PCE inflation, rose 0.2 percent in October and 1.7 percent annualized with the Core PCE inflation index, excluding food and energy.
Those gains signal inflation is inching closer to the Fed’s 2 percent inflation target.
According to the 2nd estimate of U.S. GDP in third quarter of 2016, the U.S. economy grew 3.2 percent, higher than 2.9 percent in the first advanced estimate.
The November non-farm U.S. payroll jobs report shows that the U.S. economy added 178,000 jobs while the U.S. unemployment rate dropped 0.3 percentage point to 4.6 percent, the lowest level since August 2007.
Over the past 3 months, U.S. job gains have averaged 176,000 per month and, for the year, average hourly earnings have risen by 2.5 percent.
The U.S. Federal Reserve decided to raise interest rates in December 2015 for the first time since 2006 and they did so by increasing the benchmark rate at the federal funds by 0.25 basis points from 0- 0.25 percent to 0.25- 0.50 percent.
In periods of interest rate hikes and tightening with monetary policy, typically the currency of the country that adjusts their monetary policy strengthens and the yields on their Treasuries tend to rise.
U.S. Treasury yields have already been steadily rising since Donald Trump was elected to the U.S. Presidency in early November on the premise that inflation will continue to rise as he adopts pro-growth fiscal policies consisting of lowering taxes, lowering regulations, and fiscal stimulus (infrastructure spending).
The yield on the U.S. 10 yr. Treasury is currently 2.51 percent and just made a 52 week high.
The U.S. dollar reached a 14 yr. high in late November during the so called Trump rally and remains elevated compared to a basket of major currencies.
A strong U.S. dollar combined with rising crude oil, inflation, and U.S. Treasury yields creates a unique phenomenon for the economy which comes as U.S. monetary policy is expected to diverge from monetary policies of other major economies such as the EU (ECB) and Japan (BOJ) that remain committed to maintaining dovish monetary policies heading into 2017.
The Week Ahead
Investors will have a busy economic schedule this week.
Besides paying attention to the outcome of the Fed’s 2 day monetary policy meeting, investors will also be watching a string of economic reports due on Wednesday for further clues about the resiliency of the U.S. economy.
November retail sales will be reported on Wednesday.
Economists from briefing.com have a consensus estimate that retail sales increased 0.3 percent in November after retail sales rose 0.8 percent in October.
Some of the other economic data that is due on Wednesday includes PPI inflation (November), Industrial Production and Capacity Utilization (Nov.), Business Inventories (Oct.), Crude Inventories, and the MBA mortgage index.
On Thursday CPI inflation is due for November alongside Markit Flash U.S. Manufacturing for November, Continuing and Initial claims, Philadelphia Fed (Dec), Empire Manufacturing (Dec.), NAHB Housing Market Index (Dec.), Natural Gas Inventories, and Net Long Term Tic Flows.
On Friday Housing Starts and Building Permits for November will come into focus.