The real interest rate differential is shifting in favour of the US market, making the latter a relatively-attractive destination for the portfolio flows.
The keenly-awaited minutes of the US Fed’s January 2018 meeting, which were released on Wednesday, prime an increased confidence on US economic outlook and firm up inflationary concerns.
Not surprisingly, after the Fed meeting minutes were released, market-implied probability for three rate hikes this year inched up to 37.1 percent and the probability of a rate hike in the March 21 meeting went up to 86 percent from 72 percent a month ago.
Table: Target rate probability – CME group
Economic projections indicate upward trajectory
Going by the minutes, the Federal Reserve was upbeat on growth indicators like real final domestic purchases by households and businesses that are considered a good gauge of the economy’s underlying momentum.
After an economic review, the forecast for real GDP growth was revised upwards for the current year, partly reflecting an impact of the recently-enacted tax cuts, along with optimistic outlooks on equity prices and international economic growth.
According to the minutes, real GDP was projected to increase at a somewhat faster pace than potential output through 2020.
Inflation projections are revised upwards
The Federal Reserve’s projection for inflation over the medium term was revised upwards, taking into account tighter resource utilization in the January forecast.
Core PCE prices were forecast to rise faster in 2018, keeping in mind both the expected waning of transitory factors that held down 12-month measures of inflation in 2017 as well as the projected further tightening in resource utilization.
The Fed projected that core inflation would reach 2 percent in 2019 and that total inflation would be at par with the Committee’s 2 percent objective in 2020.
Inflation projection risk balanced
As mentioned in the minutes, risks to the projection for inflation were seen as balanced. Downside risks included the possibilities that longer-term inflation expectations may have edged lower or that the run of soft core inflation readings this year could prove to be more persistent than the staff expected.
These downside risks were seen as essentially counterbalanced by the upside risk that inflation could increase more than expected in an economy that was projected to move further above its potential.
Interestingly, many staff participants reported that labor market conditions were tight in their districts based on low unemployment rates, difficulties in filing vacancies or retaining workers. The unemployment rate, at 4.1 percent, had remained near the lowest level seen in the past 20 years.
Additional data adds to more conviction for projections
Interestingly, the minutes encapsulate the Board’s view, which came before the release of two important indicators i.e. a 2.9 percent YoY increase in average hourly wages (January- non farm) and a 0.5 percent MoM increase in the consumer price, giving further impetus to Fed rate hike probability and bond yields.
Note: Sticky CPI - Calculated from a subset of goods and services included in the CPI that change price relatively infrequently.
Yield curve steepening revives
While the last quarter of 2017 was defined by a flattening yield curve, wherein short term interest rates surged faster than long duration ones leading to a sharp reduction in the difference in yields on 10-year and 2-year US treasury yields, the current year has seen the yield curve steepen.
Normally, a yield curve steepening scenario indicates improving economic outlook. The US 10-year treasury yield has surged more than 50 bps in current year.
However, although yields have inched up in Indian market too, the real interest rate differential is shifting in favour of the US market, making the latter a relatively-attractive destination for the portfolio flows.
In this context, FII outflows seen recently in the Indian market can possibly extend further, particularly given the recent series of corporate governance slip-ups, and firming up of input cost pressure trend challenging nascent earnings recovery to some extent.Moneycontrol Research Page.Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.