• Federal fund rate stays put. The Federal Open Market Committee (FOMC) unanimously voted to maintain the Federal Fund Rate range at 1.00%-1.25%. This comes after the FOMC last raised rates in June by 25 basis points (bp).
• No immediate guidance. While there were some tweaks to the Fed’s statement, July’s statement were similar to that of June though the wording suggests a slant to a more gradual normalisation of monetary policy.
• Little immediate catalyst for OPR change. Notwithstanding the likelihood of a third rate hike in 2017, we believe that the neutral OPR stance will likely be unchanged in the absence of sustained demand-pull inflation domestically.
• Ringgit appreciation bias on dovish tone. With the markets already pricing in Fed’s status quo for July, we expect the USDMYR pair to be stable overall. However, on the Fed’s relatively dovish overtones, we expect a mild appreciation bias for the ringgit moving forward, trading towards the midpoint of the 4.20-4.30 range in the medium term.

Unchanged as expected. The FOMC maintained the Fed Fund Rate at 1.00- 1.25%, in a move anticipated by all 90 respondents on Bloomberg’s survey. This was echoed by the implied probability of the Fed Fund Rate futures which assigns a 0.0% probability of a July rate hike.

The FOMC last raised interest rates by 25bp in June, citing labour market strength and bright overall economic outlook though the FOMC acknowledged the stubbornly soft inflation trend.

Tiny tweaks. The FOMC notably dropped references that the job gains have “moderated”; instead, describing job gains as “solid on average”. The Fed also noted that household spending and business fixed investment “have continued to expand”, continuing the theme of a household spending pickup from the June statement. On inflation, the Fed noted that inflation have declined and running below its 2% target; June’s statement described inflation as just being “somewhat below 2%”.

“Relatively soon”. The FOMC was notably coy in discussing its timetable for the bond normalisation, repeating the Fed Chair’s, Janet Yellen, comments that the bond normalisation would occur “relatively soon”. Interestingly, this drops the June’s reference that the balance sheet normalisation would be implemented “this year”.

OUTLOOK

Low market conviction for third rate hike. While the case of a Fed rate hike in July was never a credible proposition, especially in light of soft inflation data, the market have consistently touted the possibility of a third rate hike, possibly either in its September or December meeting (coinciding with the Fed’s revised summary of economic projection). Presently, the odds of a September rate hike stands at a mere 10.1% while the corresponding odds of Fed Fund rate raised to 1.25-1.50% stands at 45.4% for December, just under a coin flip. The implied Fed Fund Rate probability further suggests that the Fed’s March 2018 meeting is the first point where the odds of a rate hike improve above a coin flip.

Job market strength intact; teething growth concerns.The US labour market continued to demonstrate resilience, adding 222,000 nonfarm jobs in June (May: 152,000 with unemployment rates remaining stable overall at 4.4% as at June (May: 4.3%), at the lower end of the 12-month range of 4.3-4.9%. However, even some of these positive labour market narratives have levelled off. Changes in labour market index remain positive at 1.5 as at June (May: 3.3) though June’s figure was the lowest in six month. Growth in private payrolls have also flattened, adding just 158,000 jobs compared to 230,000 jobs in May, More importantly, wage growth has remained muted, growing by just an annualised 2.5% in June, similar to that of the previous month. This may have weighed against retail sales as the Bureau of Economic Analysis showing that retail sales and food services 4.2% YoY in June (May: 4.6%), its second consecutive deceleration thus far.

The inflation poser. Weaker wage growth drives home the FOMC doves’ point that the persistently lacklustre may warrant a pause in its rate hike agenda. The consumer price index grew by just 1.6% in June (May: 1.9%), decelerating for the fourth consecutive month since February’s 2.8% inflation, its lowest since November. Core CPI inflation meanwhile grew by just 1.7%, similar to that of May. The Fed’s preferred measure of inflation, the core PCE index, saw likewise soft inflation, rising by just 1.4% YoY in May (Apr: 1.5%), relative to the Fed’s 2.0% and indeed the Fed’s 2017 projection of 1.7% (revised down from 1.9%) With no immediate catalyst for stronger inflation in 3Q17, especially as cheaper energy prices ease price pressures, we expect soft inflation to weigh against FOMC hawks.

Upcoming balance sheet normalisation. While the timeline on the balance sheet normalisation remain vague at best, it was largely anticipated given the spectre of soft inflation. However, it would be prudent to project the Fed to commence the bond portfolio normalisation by this year, indeed, as early as September (or at least by December), given the relatively small magnitude of its bond portfolio reduction. However, like its rate hike trajectory, inflation, job market strength and growth numbers will be instrumental in determining the timing of such portfolio reduction. This is backed by comments from Dallas Federal Reserve Bank (FRB) President (Robert Kaplan) and Philadelphia FRB President (Patrick Harker) suggesting a balance sheet trimming “as early as September”.

Policymakers divided. Among policymakers, the tone appears to be dovish overall with Chicago FRB president, Charles Evans, describing the persistent undershooting of the 2.0% inflation goal as “a serious policy outcome miss”. In conjunction with the relatively soon balance sheet normalisation, though, Fed Kaplan advocated a slower removal of policy accommodation. Indeed, the tinge of caution has become more prevalent with Minneapolis FRB chief, Laird Brainard, and St Louis FRB Chief, James Bullard, urging more cautious on soft inflation before raising rates. Outliers to these increasing cautious tones include Cleveland FRB President, Loretta Mester who advocated continued rate hikes, arguing transient inflation weaknesses.

Two rate hike scenario increasingly likely. While it would be imprudent to overrule the case for a third rate hike, these odds are consistent with our stand that there will likely be just two rate hikes for 2017. Indeed, July’s Fed statement was dovish enough to acknowledge weaker inflation on one hand, while being quick to remind markets that it remains committed to its policy normalisation objectives. That notwithstanding, we believe that it would take a significant pickup in 3Q17 inflation, along with a resilient labour market condition, to build the case for the third rate hike. However, with the persistently slow pickup in inflation during 2Q17, the odds of a four rate hike scenario, as touted by some of the more hawkish Fed policymakers early this year, is significantly diminished.

OPR trajectory not likely affected. The OPR trajectory is likely to remain relatively unaffected by the FOMC announcement, especially as status quo prevails. We expect the OPR to remain in neutral gears for the rest of 2017, staying at 3.00%. Domestically, demand pull factors remain manageable overall; indeed, inflation have continued to level off its 5.1% peak in March; inflation since tapered to 3.6% in June (May: 3.9%) on continued moderation of energy prices. Strengthening of Malaysia’s fundamentals may build up a case for raising the OPR moving forward though we believe that the MPC is unlikely to pre-emptively tighten its monetary levers in the absence of multi-period signs of strength.

Dollar weakness, ringgit’s gain. With the dollar index hitting a 10-month low in the build-up towards the FOMC July announcement, we expect the lack of FOMC’s optimistic overtones to see the dollar to remain on the downside in the medium term. In the context of the USDMYR pair, we expect the immediate impact to be muted overall, given that the FOMC’s move has effectively been priced in, though the lack of a more hawkish angle in July’s statement will likely see a short-term downtrend in USD strength.

Slight positive bias on medium term Ringgit outlook. However, on the FOMC’s dovish overtones – alongside Malaysia’s improving fundamentals – we see a mild appreciation bias for the ringgit in the medium term. We expect the USDMYR to trade closer to the midpoint of the USDMYR4.20-4.30 range, moving forward. This will further be influenced by the relatively tepid progress of President Trump’s fiscal agenda, which previously fuelled the dollar strength.

Source: Kenanga Research - 27 Jul 2017