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The Fed: a rate hike cometh, time for the market to play catch up

The market has been wrong-footed once more by the Federal Reserve. The dollar is maintaining multi-month highs this morning after the President of the Dallas Federal Reserve gave the clearest signal yet that he would vote to hike US interest rates in September, if economic data remains on its current trajectory.

The market reacted to Lockhart’s comments: Treasury yields, both 10-year and 2-year, jumped by 6 basis points during Tuesday’s session. This had a knock-on effect on the dollar, the dollar index rose to its highest level since May, and remains above 97.00 as we start Wednesday.

Lockhart, a voter at the FOMC for 2015, has held a fairly neutral stance so far this year and has toed the Yellen line on policy. The fact that he is willing to speak out and say that he will vote to hike rates in September is interesting for a couple of reasons: either the next major meeting at the Fed will show a number of members breaking ranks and voting for a rate hike even if Chair of governors, Yellen, fails to do so, or Lockhart’s recent stance is a sign that many members of the FOMC, maybe including Yellen herself, are willing to hike rates next month. Either way, this is a hawkish shift in Fed commentary.

The first rate hike in 8 years…

Although we have been well prepped by the Fed for a rate hike for many years, the Federal Funds futures rate, a good gauge of market expectations for Fed interest rates, has not priced in the prospect of a rate hike for September, only looking for one rate hike by the end of the year.

Now that Lockhart has sounded a note of comfort around the prospect of a rate hike next month, the market is likely to rush to price in a rate hike for September, which could be just what the dollar needs to reignite its prior rally.

September/ December, does it matter?

Yes, it does. A rate hike in September could increase the number of rate hikes in the next 12-18 months. Although we believe that the Fed will take this rate-hiking cycle slowly, we believe that a September rate hike will fundamentally shift Fed Funds futures curve, which may rise sharply and we could see rate expectations for the end of 2016 rise from their current conservative stance of below 2%, towards the 2.5%. This could be a powerful driver of the buck for the coming days and weeks.

It’s all about payrolls:

Lockhart did say that the current trajectory of US economic data was the main reason why he was willing to vote for a rate hike next month, thus this Friday’s NFP report will be critical, a strong reading could see the dollar extend its recent rally and end the week on a high note. Whereas a disappointing NFP report, say 150k or lower, could trigger a dollar reversal and some tempering in US bond yields, as the prospect of a rate hike next month would once again be thrown into disarray.

The technical outlook:

We believe that a 220k+ payrolls reading on Friday could be enough to lift the dollar index above 100.00, which is vital if the dollar rally is to get some legs through to the end of the year. We continue to believe that the EUR and JPY are more vulnerable to a dollar rally than the pound, which could remain volatile as we lead up to the BoE’s Super Thursday!

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