OVERVIEW

• Federal fund rate raised 25bp. The Federal Open Market Committee (FOMC) voted to raise the Federal Fund Rate range by 25bp to 1.00%-1.25% in an 8-1 decision. The FOMC last raised rates in March by 25 bp.

• Cautious on interest rate trajectory. While sticking to its median projection for three rate hikes in 2017, the Fed’s tone were somewhat more cautious as it acknowledged moderation in job growth and weak inflation.
• Normalising Fed’s security holding. The Feds also revealed some details on its proposed gradual reduction of its USD4.2t bond portfolio though the precise timing of the initiation was not revealed.
• Minimal Fed impact on OPR trajectory. Beyond affirming BNM’s views of elevated growth in the advanced market economies, we believe that the Fed’s interest rate decision is not likely to sway the Monetary Policy Committee’s (MPC) policy decision in the near term. However, strengthening domestic growth may prompt a mild tightening bias among the MPC though OPR is expected to remain at 3.00% in the near-to-medium term.
• Ringgit appreciation bias maintained. In the short-tomedium term, we believe that the USDMYR pair will be strongly guided by fundamentals projected to trade at the lower end of the 4.20-4.30 range in the near term, grounded on Malaysia’s improving economic prospects even as US growth appears to lose some momentum. On that note, we are revising our year-end USDMYR forecast to 4.15 from 4.35 previously.

Federal Fund Rates raised 25bp as anticipated. The FOMC’s move to raise rates by 25bps, in an 8-1 decision, was largely within expectations with 95 out of 100 respondents on Bloomberg’s survey anticipating the move. The case for a June rate hike has been building up since late March where the Fed Fund implied probability of a rate hike (post-March Fed meeting) edged up above a coin flip. This was subsequently bolstered by the Fed’s sanguine tone during its May meeting where it downplayed softening inflation and slower economic activity. As at 14 June, the Fed Fund implied probability of a rate hike stood at around 97.0%.

Tempered optimism on tightening trajectory. In contrast to its May’s statement and despite retaining broad optimism in labour market strength and overall economic outlook, the Fed was careful to acknowledge persistently low inflation. While Chair, Janet Yellen, expressed confidence that inflation is likely to strengthen in the medium term, the overall tone of the statement dialled down on the optimism seen in its May statement. While acknowledging the soft inflation trend, Yellen’s press conference proceeded to note that the monetary policy is not on a preset course and it would be unwise to “overreact on a few readings”… as “data on inflation can be noisy”.

Mild adjustment in economic projections. The Feds economic projections saw some adjustments, reflective of the narrative of tightening labour market, moderate expansion in economic activity and lower-than-expected inflation progression. Median projections for unemployment were adjusted downwards to 4.3%, 4.2% and 4.2% respectively for 2017, 2018 and 2019, from their March projection of 4.5% from 2017-2019 while longer run unemployment were also adjusted down to 4.6% from 4.7% previously. The median projection for GDP growth was also dialled up a notch to 2.2% for 2017 from its previous projection of 2.1% growth though projections of GDP growth beyond 2017 were broadly unchanged. In acknowledging continued low inflation, projections for PCE inflation and core PCE inflation were adjusted down to 1.6% and 1.7% respectively, from their prior estimates of 1.9% for both PCE and core PCE inflation. However, it is worth noting that inflation projections for 2017-2019 remained broadly unchanged.

Some details on possible balance sheet cut. In an addendum to the policy normalisation principles and plans, the Fed provided some details on its plan to reduce its securities holding. The policy normalisation will come in the form of gradually decreasing its reinvestments of principal payments, setting the initial reduction cap for Fed’s Treasury holdings at USD6b/month before increasing the cap at USD6b increment per quarter for a 12 month period (ending at USD30b/month). Similarly, agency debt and mortgage backed securities will likewise be shed with an initial cap of USD4b/month, with incremental increase in the cap of USD4b per quarter for a 12 month period. However, conspicuous by its absence is the timing of the balance sheet cut, beyond the cryptic phrase, “relatively soon”. Beyond these details, the Fed stressed that the target range for the Fed fund rates remain the primary lever of monetary policy.

OUTLOOK

Third rate hike still up in the air. Despite the Fed’s median estimates of three rate hikes for 2017, we believe that the case for an additional rate hike for 2017 remains tentative. The latest Feds’ statement suggests that while it is reluctant to deviate from its charted course for rate normalisation, it acknowledges that medium term inflation trajectory would be instrumental in building its case for yet another rate hike.

Labour market strengthening but cracks appearing. US improving job market in recent times have been supportive of the Fed’s case for raising rates. The ADP report showed strong growth in job creation, adding 253,000 in May, easily beating Reuters’ 185,000 consensus estimates (ranging from 155,000 to 240,000 jobs added) while unemployment rates fell to 4.3% (Apr: 4.4%). The Fed’s “change in labour market conditions” index has also remained relatively strong by historical standards at 3.5 index points. However, wage growth remains disappointing with average hourly earnings increasing by just an annualised 2.5%. Indeed, shrinking unemployment rates were somewhat marred by persistently low labour force participation rate which fell to 62.7% in May (Apr: 62.9%), stubbornly below the 65.0% levels observed in 2009. These cracks somewhat weaken exuberance on US labour market, in turn weighing against the hawk’s case for further monetary tightening.

Lacklustre inflation. Since our last assessment of US inflation trajectory in May, US continued to see a relatively soft inflation environment. Just before the Fed’s announcement, the Labour Department report saw consumer price index dipping to 1.9% in May (Apr: 2.2%) while core inflation also fell to 1.7%. Separately, the Commerce Department also revealed weaker retail sales figures of 3.8% in May (Apr: 4.6%), potentially flagging weaknesses in consumption. The Fed’s preferred measure of inflation, the core PCE index, fared no better. Core PCE inflation has showed little signs of picking up, indeed falling to 1.5% in April (Mar: 1.6%), stubbornly below Fed’s target of 2.0%. This suggests that a convincing rebound in inflation figures may be required to strengthen the hawk’s camp for further tightening; with cheaper energy prices on the horizon, it is uncertain if inflation would spike in the coming months.

Timetable for bond portfolio reduction. We believe that the Fed initial announcement on the bond portfolio reduction is grounded on their desire to provide market participants with a heads-up on possible movements in the bond markets though her reluctance to provide a timeline (beyond the term “relatively soon”) suggests lingering uncertainties if conditions is ripe for a bond portfolio reduction, particularly in tandem with the rate hike announced.

Reiterate position for two rate hikes. Considering some moderation to labour market strength along with the possibility of persistently softer inflation, we believe that our previous assessment for just two rate hikes for 2017 (i.e. no further rate hikes for the rest of the year) is justified. If anything, the Fed’s cautious acknowledgement of softer inflation is likely to reduce any urgency towards sticking to its beaten path of rate normalisation. We see some upside risk to our assessment if inflation starts picking up while labour force participation improves in the second half of the year, though this would likely lead to a third rate hike only in the Fed’s December meeting.

Fed tightening unlikely to alter MPC’s barometers. While statements from other major central banks, including the European Central Bank, Bank of England, Bank of Canada, among others, have indicated a gradual tightening bias, we believe that the

Fed’s interest rate decision not likely to prompt other central banks to follow suit in the near future. However, the Fed’s move may inject a mild tightening bias among other central banks towards an eventual tightening, depending on their respective prevailing economic conditions.

OPR to remain unchanged. In the case of Malaysia, we believe that the FOMC’s decision is not likely to sway the MPC towards raising the OPR above the current 3.00%, beyond affirming continued strength in advanced market economies. However, with some strength observed in aggregate demand and potential pickup in demand pull inflation moving forward, we could see the Fed’s decision being a consideration for a mild tightening bias by BNM though this bias is unlikely to be exercised in the medium term given stable inflation trends in Malaysia.

Mounting risk to pare down dollar strength. Meanwhile, we are not convinced by Yellen being dismissive of anything that might suggest softness in the US economy during her press conference. This is contrary to the dovish tilt that she projected three months ago. In her view, the gap between market (dovish) and the Fed (more hawkish) expectations is “not unhealthy.” With the inflation (core PCE) to remain below the 2.0% target, employment condition deteriorating and mounting political issue in Washington it may pose a challenge for the Fed to stick to their aim for another rate hike this year. Hence, we believe this would pare down the US dollar strength expectation going forward.

Ringgit prospects to remain bright. This, however, does not change our view that the ringgit outlook would improve going forward as improving fundamentals are increasingly outweighing the risk of further US rate hikes. With the ringgit presently at MYR4.26/USD just before the Fed’s announcement, we believe that the Fed’s decision is not likely to have a significant long-term impact on our ringgit outlook beyond some transitory knee-jerk movements in the USDMYR pair. Moving forward, we believe that the USDMYR will trade at the lower end of the 4.20-4.30 range in the near future from a confluence of a pickup in Malaysia’s growth, along with signs of US growth stalling while it seeks to regain its momentum.

Ringgit forecast revised up. Our positive view on Malaysia is grounded in our sanguine outlook on Malaysia’s fundamentals, at least relative to historical terms. This is especially true given a stronger-than-expected 5.6% GDP growth in 1Q17 even if we see growth tapering somewhat – but remaining elevated – towards 2H17. Furthermore, stabilisation of financial flows to Malaysia, with renewed global interest in Malaysian bond and equity markets, will likely provide a strong longer-term momentum for a relatively steady appreciation of the ringgit. Hence, we are revising our year-end USDMYR target to 4.15 from our earlier projection of 4.35

Source: Kenanga Research - 15 Jun 2017