Yellen hawkish, but dovish US data suggests no threat to FII flows to India

Federal Reserve Chair Janet Yellen holds a news conference following day two of the Federal Open Market Committee (FOMC) meeting in Washington, U.S., December 14, 2016. REUTERS/Gary Cameron - RTX2V2DG

Anubhav SahuMoneycontrol Research

As expected the Federal Reserve raised the policy rate by 25 bps post its two-day Fed meeting. While Fed projections signal a further rate increase this year, markets aren’t quite pricing this in.  At home, our view is that the RBI will remain in wait-and-watch mode, meaning that the interest rate differential (US vs India) may not necessarily narrow in the near term.

In a follow-up conference, Fed boss Janet Yellen expressed confidence in the economic outlook and raised the projection for GDP growth (2.2 percent in 2017 vs 2.1 percent earlier) and lowered the unemployment rate expectations to 4.3 percent in from 4.5 percent.

Core inflation data (excluding food and energy), which came yesterday at 1.7 percent, however, signaled softness (consensus expectation of 1.9 percent). The Fed’s own inflation tracker PCE (personal consumption expenditure) inflation rate has recently softened after peaking in January. However, Yellen sees this recent softness in inflation data as transitory and maintains that inflation should stabilize around 2 percent over the medium term. However, at the same time, in the near term (12 month basis), the Fed expects inflation to remain below 2 percent.

Despite Yellen’s moderately hawkish stance, bond markets decided to pay heed to hard data and witnessed a flattening of the yield curve. This means bond yields declined across the term structure and longer term bond yields (30 years, 10 years) declined more than that of the shorter term (5 years, 2 years).

US PCE inflation rate trajectory

Source: FOMC

Dollar index did a bit of U turn – it first declined but then recovered as Yellen was a bit hawkish. However, it has since then been flat, apparently not taking Yellen’s guidance too seriously. Stocks reacted mildly negatively but also due to weak dynamics for the technology and energy sector.

Fed’s projection for inflation rate: To reach 2 percent by end of 2019

Source: FOMC

Talking about Fed’s median expectation for the policy rate path, it is centrally unchanged from the last meeting. This essentially means expectation remains for one more rate hike of 25 bps this year (2017 Fed’s median projection: 1.4 percent), followed by three such rate hikes in 2018 (2.1 percent) and 2019 (2.9 percent).

Fed policy rate dot: March 2017 vs June 2017

Source: FOMC

Are the markets willing to believe the Fed?

The probability of one more rate hike in the current year has dropped significantly. As per the pricing of Fed Funds futures contracts, probability of another rate hike this year has reduced from 48 percent to 28 percent, signifying broadly lower inflation expectations.

The Federal Reserve also outlined its plan to shrink its USD 4.5 trillion balance sheet in 2017 itself. Yellen highlighted that the unwinding plan could be put into effect relatively soon if the macro data evolves as per Fed’s expectations. This would eventually reduce the reinvestment of principal payments received on maturing securities in its portfolio. Normalization of Fed’s balance sheet is expected to be negative for bonds and eventually adds to the tightening of monetary policy.

Is Yellen ahead of the curve?

So, as per the current set of data, barring labour market improvement, Yellen’s stance appears to be ahead of the curve. Market is not factoring in another rate hike this year. Further, recent set of macro data have fallen short of consensus expectations. Not surprisingly, US economic Surprise Index has also fallen sharply in the last couple of months. Yesterday, retail sales data didn’t point to robust domestic demand. Given this context, we don’t see any strong case for further rate hike in the current year unless macro momentum and underlying inflation improves.

Turning to India, RBI continues to have a neutral stance on policy rate front. Though a persistent low inflation and weak growth dynamics could prompt a rate cut action, we think the RBI would remain in the wait-and -watch mode for a better understanding of inflation trajectory and the likely disruption due to GST implementation.

Hence, in the near term, interest rate differentials (US vs India) could remain stable and we may not see reversal in foreign fund flows (about 7 billion in 2017 YTD) on account of that.

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