Key Market Factors in 2017 – Rate Hike Expectations, US Policy

As the first quarter of 2017 comes to a close,one of the focal points for global investors is the US stock market. From the US presidential election until mid-March when China Forex went to print,the Dow has been on a steep climb,setting a new milestone at nearly 21,170 points,for a gain of some 3600 points or 21% since election day. Similar advances were seen in the NASDAQ composite as well as the Standard & Poor's 500 index.

The gains were not just in the US market as Germany's DAX,the UK's Footsie and Hong Kong's Hang Seng Index all recorded significant advances. However,it was not just the extent of the climb that was so impressive. The lack of a real retracement has also been an eye-opener. Moreover,this steady climb by the equities market,contrary to the trend on the foreign exchange and commodities markets,clearly illustrates the difference in sentiment between the equities and the FX or commodities markets.

Post-Election Market Sentiment

Let's briefly review the situation shortly ahead of the US election before diving into current market conditions. Market sentiment was then driven by "uncertainty," resulting in an influx of funds into risk averse assets such as the Japanese yen and gold.

After the election results were announced,an abrupt change of market trajectory took place,as market sentiment changed from risk averse to risk embracing. The yen lost ground and gold prices started falling while the greenback advanced. However,unlike the equities market,the greenback's upward trend stalled after December 15. The ICE dollar index peaked at about 103,forming a "double top." Gold prices and the dollar/yen reacted to a weaker dollar by subsequently forming a "double bottom" and "double top," respectively. Gold prices rebounded from their year low of around US$1,125 and the Japanese yen started to appreciate again as the dollar/yen began a retracement after its 1800 pip gain since the US election. The uptrend of the greenback was halted after mid-December,but what caused the market to react in such a manner?

On December 15,2016,the Fed's Open Market Committee announced that it was raising interest rates again (its first hike in a year) and it signaled that there would be three more rate increases this year. Nonetheless,market sentiment responded by leaning towards a bearish greenback,which resulted in the topping out of the ICE dollar index. At that point,some observers stipulated that the weakening of the index was temporary and represented a technical retracement.

However,on March 2,the Chicago Mercantile Exchange put the likelihood of a rate hike at more than 66%,nearly doubling the odds calculated on February 28.

This abrupt change in market sentiment resulted in the greenback gaining strength once again and the shift echoed through the commodities and foreign exchange markets. Gold prices were pushed US$40 lower while the dollar/yen rallied nearly 300 pips in one week.

In retrospect,given the chain of events,the topping out of the ICE dollar index after the most recent rate hike in December was perhaps an indication that the market was in doubt as to whether the Fed would be able to keep pace with its projected rate hike frequency in 2017. Hence the reaction shouldn't be considered as a mere technical retracement.

After mid-December,market sentiment was again geared towards uncertainty. Market participants feared they could see a repetition of the interest rate scenario of a year earlier. At the time of the December 2015 rate increase,the first hike in 10 years,the Fed's Open Market Committee also signaled three more rate hikes for the year ahead. But the Fed didn't follow up on that indication to the market until the year-end. This was reflected in the peaks and troughs on the yield of the 10- and 30-year US treasury bonds,which correlated completely with the trend of the ICE dollar index.

Market conditions in the first quarter of 2017 and the last few months of 2016 seemed to be strongly oriented towards expectations of a Fed rate hike. This has been as a very strong focal point for the dollar and has corresponded to the many immediate formations of tops and bottoms in the FX,bond and commodities market.

Given such behavior,it is likely that the dollar's strength will  closely correspond to the monetary policies of the Fed over the course of 2017. Any deviation from the initial planned path of three rate hikes should result in a weaker dollar.

What to Expect from the US Economy

Whether or not the Fed will adhere to its charted course depends heavily on economic data. Resounding statements have been made multiple times by FOMC chair Janet Yellen as well as other FOMC voting members. Below let's take into account some of the most recently released figures regarding inflation,GDP and the employment situation in the first quarter of 2017,and see if any conclusion can be drawn on whether or not the economy can withstand a 75-basis point increase in interest rates.

Inflation

The January personal consumption expenditure data released on March 1,showed a gain of 1.9% over the same month a year earlier. There was also a 0.4% increase from December. The increase was the largest since February of 2013,and the personal consumption expenditure index also reached an all-time high of 112.08 points. From a year-on-year perspective,the core price index also showed an increase of 1.7%.

By reviewing another inflation-related indicator a similar conclusion can be drawn. The most recent consumer price index data released on February 15 also showed that consumer prices in January exhibited a year-on-year rise of 2.5%. Beating market expectations,this figure represented a sixth consecutive month of acceleration.

Over the past six months,these indicators showed steady growth trends. Both indicators demonstrated that inflation is moving in the right direction,as far as the Fed is concerned,and the Fed's overall inflation target of 2% might already have been reached. If inflation numbers remain strong after interest rates have been raised by another 25 basis points in March,a further increase of 25-50 basis points would be most likely in 2017 as a pre-emptive measure to keep the economy from overheating.

GDP

Quarter-on-quarter growth in real GDP in the final quarter of 2016 was confirmed at an increase of 1.9% and annual GDP growth was 1.6% - the lowest since 2011. However,a summary of the fourth quarter GDP highlights from the Bureau of Economic Analysis shows that the increase in the real GDP in the fourth quarter was mainly due to higher consumer spending and some types of investment but those contributions were mainly offset by declines in exports and federal government spending.

If the offsetting factors were from lower exports and federal spending,it is not inconceivable that the Trump administration could reverse these conditions. As he has stressed numerous times,President Trump's goals include increasing infrastructure spending and using tariffs to benefit American companies. More than two dozen US business giants,including Boeing,General Motors and Oracle,have formed a lobbying group called the "American Made Coalition" to support the administration's planned "border tax" reform blueprint.

Labor

Labor and unemployment are essential factors in judging whether an economy is in a healthy state. To date,the economic data released in the first quarter of 2017 seem relatively promising. The January non-farm payroll figures showed an increase of 227,000,much higher than the market consensus of 175,000 or the 151,000 released in the same month a year earlier. These were 20% above the average of non-farm payroll figures for the last 12 months. February numbers were also above expectations at 235,000.

The unemployment rate held below the 5% threshold in both months,coming in at 4.7% in February.

Such figures are in line with comments on labor market conditions made by Fed vice chairman Stanley Fisher at the 17th Jacques Polack annual research conference in November. He stated that if labor force participation remained flat,job gains in the range of 125,000 to 175,000 should likely prevent unemployment from creeping up. The labor participation rate has remained pretty stagnant in the last 12 months and the magnitude of movement has been less than 0.4%.

Even Fed chair Yellen commented recently that the labor market in the US was stable and that the Fed had an optimistic view on the US economy. This should support expectations that the Fed will raise interest rates on a more frequent basis in 2017.

Given that most of the FOMC members have shown a more hawkish stance on