Outlook for Fed rate hikes and U.S. dollar

Probability for a Fed rate hike on Wednesday stands at about 94%, according to CME Group’s FedWatch tool. That’s no surprise, given the solid U.S. economic outlook.

“The U.S. economy is firing on all cylinders at the moment,” says TD senior economist Fotios Raptis in a weekly economics report, dated June 8.

“Growth in the second quarter is currently tracking a blistering 4% annualized pace, helped along by a strong rebound in household spending, firm business investment, and surprising strength in net exports,” he says.

Because of that strength, along with low unemployment, wage growth and rising headline inflation, the Fed is expected to raise the target range for the fed funds rate by 25 basis points on Wednesday, “with another hike or even two embedded in the updated dot plot summary for this year,” says Raptis.

Read: Why it’s a tough year for risk assets, fixed income

A hike on Wednesday would lift that target range o 1.75%-2%.

Raptis says the number of further rate hikes is uncertain, and their exact timing is open for debate.

Why? “Geopolitical risks remain elevated, and a policy misstep or two may be just enough to send financial markets, business confidence and global trade into a tailspin,” he says.

Trade skirmishes could escalate to trade wars, he adds, “particularly if talks fail to make progress between the U.S. and its major trading partners.”

Read: Investing during tough times for trade

He also notes that, as tightening cycles begin, emerging markets “remain at the mercy of nervous investors who are more concerned with capital retention than returns in such an uncertain environment. Argentina and Turkey were the first victims of speculative attacks, but they surely will not be the last during this tightening cycle.”

Despite these and other risks, the Fed is likely to stay on its current path of gradual rate hikes, says Raptis.

Read: Choosing inflation-linked over fixed-rate bonds

Fed outlook and dot plot

Josh Nye, RBC economist, will be focusing on the Fed’s updated projections on Wednesday. He says in a monthly financial markets report, also dated June 8, that there’s potential for modest upward revisions to growth and inflation for 2017. There’s also room for downward revision to the unemployment projection, Nye says.

Read: Is U.S. inflation on the rise?

“With policymakers sounding more confident [that] their inflation target will be met on [a] sustained basis, we think consensus will shift to four hikes,” he says.

Referring to the dot plot—what’s known as Fed officials’ forecasts for the central bank’s key interest rate—Nye says: “We’ll also have an eye on the 2019 dots to see if the committee sees the policy rate rising above the 3.0% ‘neutral’ rate.”

Recent comments from some Fed officials have indicated monetary policy will likely need to become restrictive at some point, he says. That view “fits with our forecast for once-a-quarter hikes to continue next year,” says Nye. “We see the fed funds rate ending 2019 in a 3.25-3.50% range.”

In a weekly financial digest from Friday, BMO’s deputy chief economist, Michael Gregory, says he expects a “mildly up-drifting” dot plot.

He forecasts two more rate hikes this year, saying, “The forecasts for 2019 and 2020 should remain unchanged at 2.875% and 3.375%, respectively (implying a couple of rate hikes each year).”

Read: Tilting away from cyclicals: Are we there yet?

Greenback blues

The U.S. dollar is expected to lose ground over the coming year, what with the Fed’s future trajectory fully priced in to markets and with tightening expected from Japan and the Eurozone, says CIBC deputy chief economist Benjamin Tal in a weekly economics report for June 11 to 15.

However, any prediction on the U.S. dollar shouldn’t be made with much conviction, he cautions, citing emerging markets volatility as one reason.

Read: Where to capitalize on currency

While still relatively narrow, emerging markets–U.S denominated spreads have widened notably in recent months, “clearly a reflection of increased concern related to the impact of rising U.S. yield and a stronger dollar on EM dollar-dominated debt,” says Tal.

He explains that outstanding non-financial EM corporate debt has risen significantly, and there’s a risk that servicing that debt could become increasingly difficult with the recent increase in U.S. yields.

That situation could result in increased EM volatility, Tal says, “leading to a safe haven–induced dollar appreciation, which then would work to intensify the credit shock and push the dollar even higher. That’s exactly the opposite of what the market is expecting now.”

In the same CIBC report, Royce Mendes, director and senior economist, says, “Market-implied pricing currently calls for more than the two rate hikes we see by year end, which could weigh on the greenback as expectations are pared back.” For example, if emerging market volatility worsens, the Fed may take a pause on rates earlier than expected, Mendes adds.

Mendes writes that Fed chair Powell will likely mention on Wednesday that central bankers are watching EM stress. Still, “[…] it’s not yet worrisome enough to affect U.S. monetary policy decision.”

Read the full reports from TD, RBC, BMO and CIBC.

Also read: Hazards of responsible investing in emerging markets