Four Rate Hikes are in Sight for 2018 but Trade Spat Weighs on Greenback

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US Dollar fundamentals have brightened now Federal Reserve chair Jerome Powell has signalled four rate hikes are possible in 2018 but fears over a possible trade spat are weighing on the greenback. 

The US Dollar traded higher across the board Thursday as traders responded to the second appearance of Federal Reserve chairman Jerome Powell before lawmakers in Washington and the latest US economic numbers, although it has since been pushed onto the back foot by mounting concerns over a possible trade war.

The core PCE price index, or personal consumption expenditures index, rose by 0.3% between December and January, according to Bureau of Economic Analysis data. On an annualised basis, core PCE inflation rose by 1.5%, in line with its December pace.

Core PCE inflation, which removes volatile energy and food components of the consumer goods basket, is important for currency markets because it is the Federal Reserve’s preferred measure of inflation.

Earlier in February, a spike in January’s core consumer price index prompted fears of a sudden rise in inflation and a quicker pace of rate rises from the Fed, wreaking havoc on global financial markets.

It first sent the US Dollar and American bond yields surging and then sank US stock markets, which inevitably spilled over into global markets.

Separately, the BEA data showed US consumer spending rising at a rate of 0.2% during January, down from 0.4% growth in December, while personal income growth held firm at 0.4% on a month on month basis.

"January’s personal income and spending data shows underlying inflation accelerating again, although real consumption growth is weakening even with the boost to incomes from the tax cuts," says Paul Ashworth, chief North American economist at Capital Economics.

"With consumer confidence elevated and disposable incomes rising, we don’t expect the softness in spending to last long. Assuming it rebounds, rising inflationary pressures will keep the Fed hiking interest rates." 

All income and expenditure data is important to the Federal Reserve and markets because of the impact it can have on inflation. It is inflation the Federal Reserve is attempting to manage when it makes changes to interest rates.

Traders also responded positively to the Institute of Supply Management Manufacturing index for February which, rising from 58.7 in January to 60.8 last month, is at its highest level since May 2004. 

"That's a good first indicator for next week's payrolls, but the services ISM is more important in that regard," says Andrew Grantham, an economist at CIBC Capital Markets.

"The above consensus headline and prices paid data should support the US Dollar and weigh on fixed income."

The manufacturing index upturn was largely the result of a surge in new job creation within the sector, presumably as manufacturers gear up for an anticipated increase in spending as President Donald Trump's tax reforms do their work on consumers' wallets.

Thursday’s economic numbers came as Fed chair Jerome Powell appeared for a second time before Congress to provide account of the central bank’s current thinking around interest rates to the Senate Banking Committee.

Powell told lawmakers the Federal Reserve did not want to get behind the curve when it came to raising interest rates as it would risk a recession if a sudden rise in inflation forced the central bank to raise rates sharply in the future.

Markets took this as confirmation that the Fed will likely raise rates at least three times in 2018, as well as increasing the odds of a fourth rate hike.

Current pricing in interest rate derivatives markets, which enable investors to hedge against changes in interest rates and provide insight into investors’ expectations for monetary policy, suggests the market already expects an interest rate rise in March.

However, the same market pricing implies only three rate increases in total for 2018 when the Federal Reserve has room to announce a total of four, running at one every quarter. It is a change in these expectations that could generate a reaction in currency, bond and stock markets.

In his earlier Tuesday appearance before the House Financial Services Committee, Jerome Powell emphasised that US unemployment remained low at 4.1% and the labour participation rate largely unchanged in the second half of 2017, suggesting an economy that is close to full employment.

He also expressed confidence that inflation will eventually return to the 2% target, even with higher interest rates, and noted a small pickup in wage growth toward the end of last year. All of these comments denote a Federal Reserve that is likely to push ahead with further interest rate rises over the coming quarters.

"Upside USD risks we have been flagging for some time are beginning to be realized, and the dollar rally has room to run. Notably, Chair Powell's testimony this week confirms our view that markets are underpricing US growth and inflation and their potential positive impact on the USD via monetary policy divergence," says Ben Randol, an FX strategist at Bank of America Merrill Lynch.

"Our US economics team expects three hikes in 2019, and the market is priced for about one. We also see the risk of four hikes this year (currently priced for about three). As the market has already repriced the ECB, we think that a repricing of the Fed alone could push EURUSD close to our 1.15 Q2 target and the broader dollar correspondingly higher."

The Pound-to-Dollar rate was unchanged at 1.3772 during early trading Friday while the Euro-to-Dollar rate was 0.14% higher at 1.2287. The US Dollar index, which measures the greenback against a broad basket of currencies, was 0.09% higher at 90.16.

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