As we had anticipated, the U.S. Federal Reserve (Fed) raised the Fed funds target range up by a notch, i.e. 25bps, overnight. This change means the upper and lower boundaries of the Fed funds target rate are 1% and 0.75% respectively (see Chart 1). At the same time, the Fed funds rate will likely reach around 0.8% in the near term, which will be the highest level since October 2008. As the Fed has raised the interest rate twice in the last three months, does this signal a faster pace of rate hike? Does this justify a change to our call of two rate hikes in 2017?
What happened?
Since our previous update on interest rate movements in the U.S. (Economic Update on 27 February), the expectation of rate hikes has soared. Prior to today’s rate hike, as reflected by the implied probabilities of futures’ pricing, market participants had already priced in a 100% chance that the Fed would raise rates at this meeting, compared to the 36% chance implied on 24 February.
Market participants have become more convinced about the patterns of economic growth and inflation lately, as flagged by the shift of the yield curve. When we issued our last report on 27 February, long-term treasury yields were notably lower than those immediately after the rate hike in December (see Chart 2), while short-term interest rates were rather stable (Black vs. Green lines in Chart 2). Such expectations have changed since then, as short-, medium-, and long-term bond yields have all shifted up (Red vs. Black lines).
The parallel shift of the yield curve reflects the revision of rate hike expectations and a re-pricing of risks during the last couple of weeks, which may also be related to the increasingly more hawkish rhetoric of Fed officials. For instance, Fed Chair Janet Yellen said that “partly because my colleagues and I expect the neutral real Federal funds rate to rise somewhat over the longer run, we project additional gradual rate hikes in 2018 and 2019.” [1] When Fed Governor Lael Brainard spoke on 1 March, she opined that “assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path.” [2]
As a result, the three-month Treasury yield picked up from 0.52% to 0.73% between 24 February and yesterday (+21bps), while the 10-year Treasury yield escalated from around 2.31% in late February to 2.51% (+20 bps). During the same period, the 30-year Treasury yield rose from 2.98% to 3.11% (+16bps), too. Such developments point to rising borrowing costs in the U.S.
Conclusion
According to the implied probabilities of futures’ pricing, chances of the Fed raising rates two times or more by the end of the year has increased to 53.2% (see Table 1), from 40.5% on 24 February. Moreover, as reflected by newly released projection, 14 out of 17 Federal Open Market Committee participants assessed that the Fed funds rate range should be lifted twice from current levels. Indeed, such market intelligence calls for a revision of our expectation, especially when decisions on rate hikes will become increasingly dependent on inflation, which is already around the Fed’s target.[3] Therefore, we shall revise our view, and the new projection is that the Fed may raise the interest rate two more times during the remainder of 2017.
Although adjustments in the Fed’s monetary policy stance is still expected to be “gradual,” it should increase the cost of financing for businesses. While the peg between the Hong Kong dollar and the U.S. dollar will – in theory – force interest rates to go up in Hong Kong as rates go up in the U.S., we maintain the view that banks in Hong Kong still have room to avoid raising interest rates through adjustment of the best lending rates in the near term, given the abundant liquidity in the system.
Nevertheless, businesses and individuals should be warned against overleveraging – especially if they are exposed to lending products that are more sensitive to interbank rates (i.e. Hong Kong Inter-bank Offered Rate), which are already showing a more volatile pattern in recent months (see Chart 3).
[1] Yellen, J. L. (3 March 2017) From Adding Accommodation to Scaling It Back. [2] Brainard, L. (1 March 2017) Transitions in the Outlook and Monetary Policy. [3] While the PCE inflation numbers have not been published, CPI rose 2.7% YoY in February
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