US Fed to hike rates seven times in 2017-18, says Morgan Stanley

Later today, US Fed is widely expected to raise key rates by 25 basis points

Analysts at Morgan Stanley expect the US Federal Reserve (US Fed) to hike rates seven times in 2017–18, which is more hawkish than the five times priced in by the Fed Futures, writes Deyi Tan, an economist with Morgan Stanley in a co-authored report.

Co-incidentally, the US Fed at the end of its two-day meet later today, is widely expected to hike key rates by 25 basis points – the second time in three months – encouraged by strong economic data as represented by monthly job gains and the confidence that inflation is rising as per expectations. Most analysts and markets will be eyeing the commentary on the pace of hikes going ahead.

“The recent employment report is likely to have convinced the FOMC to go ahead with the rate hike that they carefully signalled to the markets earlier this month. The Fed’s urge to hike only three months after the December hike, being very hesitant only a month ago at a meeting that revealed a lot of uncertainty regarding the fiscal policy plans of the new administration and its impact on the economy, suggests that the Fed is now making the same bet on fiscal policy as the markets. This suggests that the ‘animal spirits’ that are boosting the markets have reached the Fed as well,” said Philip Marey, senior US strategist at Rabobank International in a recent note.

Meanwhile, analysts at Morgan Stanley suggest that the two US Fed tightening cycles in 2004–2006 and 2013–2014 represent two ends of the spectrum when it comes to the impact from funding pressure and export recovery.

“The 2004-2006 cycle showed that Fed tightening could be very benign. External funding pressure was limited, thanks to improved external balances and delivered balance sheets following the Asian financial crisis (AFC). At the same time, Asian exporters rode the export boom as US consumers levered up & China joined WTO,” the report says.

Adding: “But the 2013-2014 tapering was a different ballgame: There was significant funding pressure as current account balances weakened or fell into deficit and balance sheets had levered up significantly. Meanwhile, export support was scant as US consumers delivered and China faced excess capacity.”

Morgan Stanley analysts believe that the 2017-2018 US Fed tightening would be a cross between the past two cycles. 

"The expected rise in US yields is unlikely to severely affect economies in ASEAN, Korea and Taiwan as external imbalances have narrowed and real rate differentials have gone higher, for current account deficit economies. However that said, whilst export momentum looks better than 2013- 2014, it is unlikely to reach the strength seen in 2004-2006," the Morgan Stanley report says.

In this backdrop, they prefer economies with positive structural fundamentals & endogenous growth stories. As a strategy, Morgan Stanley suggests being long on Indonesian and Korean frontend/belly rates given attractive carry. 

"Within FX, we continue to prefer selling low-yielders such as Korean Won (KRW) and Thai Baht (THB), suggest being long IDR (and INR) on relative value crosses and also like selling PHP. We believe Malaysia remains the most exposed to adverse macro outcomes in the region," the report says.