The stage is set for a Fed rate hike

We believe it is all but certain that there will be a rate increase of 25 basis points announced at the Federal Open Market Committee’s next meeting, on 12-13 December. We also find it remarkable to see how the markets have recently repriced future rate increases: the market now thoroughly expects a 25 basis-point hike.

For years, there has been a disconnect between market indications and the Federal Reserve’s intentions – the “dots” – so it is good to see that this gap is finally shrinking, although it has not entirely disappeared. It is also notable that this recent shift has had no impact on financial markets, which is positive news in terms of financial stability. Recent data out of the US show a very positive outlook and a positive growth environment, which the Fed will be happy to see. These developments should make it easy for the central bank to “walk the talk” and continue down its path toward monetary-policy normalization.

A gradual increase in US inflation over the long-term

In terms of its longer-term outlook, the message from the Fed is a cautious one. The minutes from previous FOMC meetings show balanced wording, yet its comments about inflation have been more constructive. In the past, the Fed faced a conundrum of a very positive environment and decreasing inflation. Now, the tone of the debate is evolving amid growing confidence that inflation will pick up slowly.

After the FOMC’s December meeting, we expect to hear positive comments about labour-market developments, which in turn should fuel gradual wage inflation going forward. As a consequence, we expect to see core inflation rise gradually in 2018, justifying de facto the ongoing monetary-policy normalisation process.

Expect the ECB’s forward guidance to evolve

Throughout 2018, we expect a large majority of European Central Bank Governing Council members to continue supporting the bank’s asset-purchase programme. At the same time, it is clear that there is a debate inside the ECB about the length of the programme and how much the central bank needs to adjust its forward guidance.

With this in mind, it wouldn’t be a surprise to see the ECB’s forward guidance evolve at its 14 December meeting in a way that cuts the link between continuing asset purchases and inflation. This evolution would take into consideration three key elements:

1. The pace of asset purchases
2. The horizon at which asset purchases would come to an end
3. The potential for optionality, given growing calls for an announced end to asset purchases while ECB President Mario Draghi is keen to maintain full optionality

We believe that the central bank’s forward guidance must evolve to reduce expectations for sustained low yields. We also believe that the ECB will have to manage expectations about the pace of future rate hikes, since this factor will gain an increasing amount of market attention moving forward.

A growing probability of three Fed hikes in 2018

Investors’ appetite for fixed income remains very strong. With this in mind, we do not anticipate any shortfalls – just look at the net inflows in fixed-income assets this year. Moreover, stretched equity valuations in the US lead us to believe that there won’t be a pronounced shift from fixed income to equities.

At the same time, the dynamics of central banks are shifting and becoming ever harder to navigate, so it is very important for investors to keep the big picture in mind. Given the ongoing divergence between central banks’ monetary policies, there is still room for a repricing of Fed hikes going forward. We anticipate at least three hikes in 2018, while the market predicts only a 60 per cent probability for those three hikes.

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