? Third Federal Fund Rate hike likely postponed. Prevailing market and economic indicators suggests that the Federal Open Market Committee (FOMC) is likely to maintain its Federal Fund Rate range at 1.00-1.25% in its coming 19-20 September meeting. The Fed last raised its benchmark rates by 25 basis points (bps) in June.

? Weak inflation diminished tightening narrative. Persistent weakness in inflation barometers is likely to remain the key challenge for the Fed’s median schedule of three rate hike.

? Impending bond portfolio normalisation. Notwithstanding the more dovish overtones with regards to Fed fund rates, the Fed is likely to trim the bond portfolio as early as the next meeting given continued signs of strength in the labour market and overall economic activity. However, debt ceiling resolution will be a key consideration in commencing the balance sheet reduction.

? Retain view of just two Fed rate hikes. Given increasing concerns on weak inflation among Fed policymakers, we believe that our view of just two rate hikes remain sustainable for the time being.

? Ringgit to be biased on the downside. While the absence of a rate hike will likely weaken the US dollar vis-a-vis the ringgit, regional tensions from North Korea may serve as a damper to ringgit strength in the short-to-medium term. Hence, we expect the ringgit to be biased on the downside and the USDMYR to range between 4.25-4.30. However, we still maintain our year-end USDMYR target of 4.15.

? No change to OPR trajectory. We expect the Fed’s decision to have limited impact on BNM’s monetary policy, which we believe will be maintained at 3.00% for the rest of the year.

Dovish tilt on monetary policy. The Federal Open Market Committee (FOMC) meets again on the 19-20 September meeting after its last meeting in 25-26 July where it retained the Fed Fund rates at 1.00-1.25%. The FOMC last raised the Fed Fund Rate during its 13-14 June meeting by 25 basis points (bp). The Federal Fund Futures implied probability for a September rate hike is virtually nil as at 5 Sep. The implied probability for a rate hike is likewise at sub-30 levels for the rest of 2017.

Low inflation poser. Core PCE reading as at July saw the core PCE inflation at 1.4% (Jun: 1.5%), below the Fed’s median forecast of 1.7% (revised from March’s projection of 1.9%) for 2017. The core PCE reading is among the Fed’s key inflation barometer. Growth in July’s headline PCE index remained subdued at 1.4% (June: 1.4%), again just below the Fed’s median forecast of 1.6% (revised from March’s projection of 1.9%). The consumer price index likewise pointed to a more benign inflation outlook; July’s inflation stood at 1.7%, just slightly higher than June’s 1.6% but significantly below its recent peak of 2.8% in February. Its corresponding core inflation was stable at 1.7% (Jun: 1.7%). That inflation has persistently undershot Fed expectations remains a key stumbling block among the hawkish camp to a speedy tightening.

Labour market health intact. The Labour Market Conditions index (LMCI), a metric previously used by the Fed in evaluating labour market conditions, have been discontinued by the Federal Reserve Board as the Board believes that it not necessarily reflective of actual labour market conditions. However, other coincident indicators suggest that the US labour market is overall reflective of an economy approaching full employment. While August’s non-farm payrolls numbers was a tad less optimistic, the markets have largely set aside those numbers as an aberration to the trend. The US added 156 thousand jobs in August (July: 189 thousand) while June’s Job Openings and Labour Turnover Survey (JOLTS) reported that job openings rose by 461 thousand, its highest increase in 23 weeks, to a seasonally adjusted 6.2m total openings. At the same time, the ADP National Employment report showed 237 thousand new hires in August, its largest monthly increase in five months. While Hurricane Harvey (and possibly Irma) may result in a temporary hit on US job growth – along with an uptick in inflation – its impact will likely be short-lived, as per the assessment of Fed Governor, Lael Brainard. Although unemployment edged marginally up to 4.4% in August (Jul: 4.3%), this remains at historical lows since the early 2000s. However, probably of more interest to policymakers is the relatively weak pace of wage growth; average hourly remains lacklustre at 2.5% (Jul: 2.8%), Weak wage growth despite stronger labour market have been a key challenge against the argument for a more rapid pace of interest rate tightening.

Fiscal stimulus likely on hold. As we previously anticipated in our report, President Trump’s ambitious plans for overarching fiscal reforms appeared to be set for a protracted battle especially as it failed to push through the repeal of Obama’s Affordable Care Act despite his Republican Party holding a commanding majority in the House of Representative and a simple majority in the Senate. Today, the reflation trade remains shakier than previously anticipated with President Trump’s pro-growth agenda stymied by internal disagreements among the administration and the Republican Party at Congress. While the political divide have been a mainstay of the legislative process, other ideological differences – such as Trump’s threat of a US shutdown over the funding of the US-Mexico border wall – have further shaken confidence over his leadership and hence, his ability to realise these pro-growth agenda.

DISSECTING FED’S COMMENTS

July’s minutes dampens rate hike prospects. Minutes from the Fed’s July meeting, released mid-August, was unambiguously dovish with some members calling for a halt in interest rate hikes. While the Fed’s meeting have previously stressed that the prevailing low inflation environment was transitory, the minutes showed that policymakers are increasingly wary on the persistently soft inflation.

...amidst increasingly dovish policymakers. The more cautious Fed minutes was further reinforced by comments from Fed policymakers to the press. Neel Kashkari (Minneapolis Fed President), the sole dissenter in the June rate hike (opting for no change in interest rates), reiterated his stand on weak consumer inflation data supportive of the case for pausing the Fed rate hike agenda. Charles Evans (Chicago Fed President), one of the more cautious policymaker likewise advocated a delay in raising rates, in the absence of higher inflation amid a faster long term economic growth rate of 2.00-2.25%. Elsewhere, Robert Kaplan (Dallas Fed President), previously in the three rate hike camp, believes that interest rates are now closer to the neutral level, warranting a more patient approach towards further tightening; Kaplan is looking for further evidence of inflation approaching the medium target of 2.0% before supporting another rate hike. Kaplan puts the neutral rate at closer to 2% (compared to 3%). John Williams (San Francisco Fed President), previously supporting “three or more” rate hikes, have likewise edged towards a more cautious stance, supporting a more gradual tightening timetable. William Dudley (New York Fed President) was somewhat more optimistic, projecting an inflation rebound over soon as productivity

growth improves. Loretta Mester (Cleveland Fed President) remains the prominent policymaker who suspects that the present weakness in inflation to be temporary. However, she noted, early-August, that the few inflation reports coming out before the September meeting will help form her longer-term inflation expectations. More recent comments by Fed policymakers reinforce this sense of dovishness with Kaplan and Brainard urging “patience” and “caution” with rate hikes. Dudley (who, in August, favoured a third rate hike) and Mester are due to speak later this week.

Balance sheet normalisation schedule untouched. Despite a more dovish view on interest rates, there is a general consensus that the trimming of the Fed’s USD4.5t bond portfolio should occur relatively soon, indeed, as early as this September’s meeting. Kashkari notes that the “big, big balance sheet isn’t doing a lot to boost the economy right now...” supporting the notion of gradually trimming the balance sheet. He is joined by fellow dove, Fed Evans and Fed Williams who believes that a September balance sheet normalisation is “reasonable” and “appropriate”. However, Kashkari warns that the present debacle of the US government debt ceiling may influence its balance sheet normalisation timetable.

Policy uncertainties to be the norm. The continued uncertainty surrounding Trump’s ambitious fiscal policy will likely continue to add an unknown variable into the Fed’s policymaking especially as these reforms appear headed into a legislative limbo. However, the absence of the reflation trade may play a more limited impact on business confidence. A survey of 3,100 people by Deloitte showed that only 5.3% of respondents believe that Trump’s ambition for tax rate of 15% (from 35%) would materialise; nearly 40% of respondents expect that political and budgetary considerations would place rate closer to 25%. Furthermore, less than 19% expects this to occur by 2017. This implies that the failure of the reflation trade may play a smaller role affecting business sentiments and hence, growth.

OUTLOOK

September rate hike unlikely. Despite comments from various Fed policymakers maintaining their median three rate hike trajectory, we are seeing increasing caution particularly from their meeting minutes and their comments to the press. This reinforces our view that a rate hike will not occur in September, or indeed, the rest of the year.

Small possibility of December rate hike. Strategically, a delayed rate hike averts the risk of removing accommodation too soon before wage growth recovers while leaving up the possibility of a rate hike in December, if inflation starts picking up subsequently. Our base case scenario puts no further rate hikes for the rest of 2017. However, we do not discount further improvements in labour market and productivity growth during 4Q17 to help nudge up Fed’s inflation expectation. With rate hikes typically occurring at the end of each quarter in the absence for a pressing need for rate changes, any decisions to raise interest rates for the third time this year will likely take place only in December; this suggests that the odds for a November rate hike are relatively remote, at best. As at 5 September, the implied probability of November and December rates exceeding 1.00-1.25% is at 0.77% and 25.35% respectively, both far from a coin-flip. This suggests that market-based probabilities have become supportive of our base case scenario of just two rate hikes for the year The case for a third rate hike for 2017 will likely have to be supported by, at minimum, evidence of a steadier pace of wage growth and possibly an uptick in core PCE inflation amid continued strength in the labour market. It is also worth noting that the Fed future implied probability of rates exceeding the 1.00-1.25% does not exceed 50% until June 2018.

Commencement of bond portfolio normalisation likely. Amid general consensus by Fed members, we believe that the balance sheet trimming is likely to begin at the September meeting. Barring any changes to the market – including Kashkari’s warning of the debt ceiling discussion affecting the timetable for bond portfolio normalisation – we expect the trimming to proceed as detailed in the June meeting, namely an initial reduction cap for Fed’s Treasury holdings at USD6.0b/month before increasing the cap at USD6.0b increment per quarter for a 12 month period (ending at USD30.0b/month). Similarly, agency debt and mortgage backed securities will likewise be shed with an initial cap of USD4.0b/month, with incremental increase in the cap of USD4.0b per quarter for a 12 month period.

OPR trajectory likely to be unchanged. Overall, the Fed Fund rate trajectory is likely to play a relatively small role in Malaysia’s OPR trajectory which will instead be influenced by domestic growth and inflation. While Malaysia saw higherthan-expected GDP growth of 5.8% for 2Q17 and a slight uptick in broader price trends, as measured by core inflation, we believe that this does not significantly change the fundamentals of Malaysia’s OPR trajectory moving forward. Indeed, despite slightly higher core inflation of 2.6% in July (Jun: 2.5%), it is noteworthy that inflation remains manageable overall and historically unimpressive, at least relative to 1Q16 which saw core inflation in excess of 3.5%, Moreover, despite signs of improved 2Q17 GDP numbers, it is worth noting that domestic demand expanded by a weaker 5.7% (1Q17: 7.7%), suggesting that a likewise more cautious approach to the OPR will be warranted.

Cautious ringgit trade on North Korea nuclear threat. While the more dovish Fed tone will lend some strength overall to the ringgit, in the short term, we believe that regional tensions – largely stemming from North Korea’s missile programme – may be a damper on investors’ sentiments. On the balance, with the US Dollar possibly weakening against other major currency and the Ringgit’s strength slightly tempered by these tensions, we expect a greater degree of currency uncertainties in the short-to-medium term. This may be somewhat balanced by a more active open market operations by Bank Negara (BNM) in attempting to stem these volatilities. For now, we expect the ringgit to be biased on the downside and trade close to the USDMYR 4.25-4.30 range, possibly testing the 4.30 levels on escalation of regional tensions. Other longer term sources of volatility may arise from BNM’s backlash against the introduction of ringgit futures at the Singapore Exchange, potentially leading to similar, albeit less drastic, volatilities which we observed during BNM’s recent attempt in clamping on non-deliverable forwards late-2016.

Source: Kenanga Research - 6 Sept 2017