Trump, tax and tightening: Dollar higher at start of jobs week with Fed policy in focus

The US Dollar began the week on the front foot after the GOP tax plans were approved, opening the door to a vast fiscal stimulus for the US economy. A big win for Donald Trump, although Dollar traders have to deal with the rollercoaster Mueller investigation, which poses a small but significant tail risk for USD if the net is ultimately cast over the president.

For the time being, USD is seeing the positives from the tax triumph. And getting the bill pretty well over the line before the Federal Reserve’s December meeting is huge as it should mean policymakers will be able to factor in lower corporate taxes into their economic projections. In September when the most recent dot plots were published, officials had yet to price in fiscal stimulus into their forecasts.

Fed officials see 3-4 hikes next year, with a 25 basis point increase to the fed funds rate already well and truly priced in for the December 13th FOMC meeting.

Given tax reform, having been approved in both houses of Congress, is now pretty well a done deal, the chances are that the Fed will turn more hawkish. This could see the median fed funds rate projection for 2018 pushed up from 2.1% to 2.3%, or even 2.5% as the Fed may be forced to tighten more aggressively than it previously though, entailing a far greater chance of 4 hikes next year, possibly more if officials see inflation significantly overshooting as unemployment falls. The 2019 median estimate could rise from the current 2.7% to as much as 3% or more. Crtically, the tax reform could force the Fed to rethink its longer run projections for interest rates, implying more elevated rates in future than is currently forecast.

The market has moved to price this in and is finally catching up with where the Fed is. Markets now price in a greater than 50% chance of at least 3 hikes in 2018. While market participants have been slow to accept the Fed is willing to tighten that fast, it is worth remembering that they have reason to be sceptical as the Fed has consistently overestimated the path of tightening.  In December 2014 the Fed estimated the federal funds rate would be in the region of 3.5% by 2017. By September 2017, rates were barely above 1% and the highest policymakers thought rates will reach in the long run is 3%.

When the December economic projections are released, the Fed may signal further hikes in 2018 than currently anticipated. However, as is their custom, the market may be slow to price in the additional tightening given experience of the Fed missing its own targets.  It will likely take additional data through the early part of 2018 for the market to catch up with the Fed again.

Treasury yields have risen and importantly what the tax reform may do is act to lift the longer end of the curve. The spread between the 10-year and 2-yr yield has risen a touch in recent days as hopes grew for tax reform to get passed by Congress. The spread has been narrowing all year, which was seen as a potential barrier to the Fed’s ability to raise short term rates.Tax reform may create additional headroom for the Fed.

Indeed the problem for the Fed may sharply shift from one of not enough inflation, to having too much and an overheating economy. This could ultimately see the Fed accelerate tightening somewhat more quickly than markets currently expect.

The next and final piece of the monetary policy jigsaw for the Fed is Friday’s nonfarm payrolls release.

The previous NFP missed with 261k jobs added in October against expectations for more than 310k.  This was the best month of jobs gains since July and the unemployment rate actually fell to 4.1% and the revisions to the prior two months means there is nothing in this to stop the Fed from hiking in December.

Nonfarm payrolls for employment for August was revised up from +169k to +208k, and the change for September was revised up from -33k to +18k , meaning employment was 90k higher than previously reported.

Of concern for the Fed is that wage growth has stalled and this raises doubts about the pace of inflation growth. Average hourly earnings rose 2.4% year on year, well down on the 2.9% reported last month and short of expectations for 2.7%. 

The forecast for the November print is  for 191,500 jobs, unemployment at 4.1% and for average earnings to have risen 0.3% for the month and 2.7% year-over-year.