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Odd Market Reaction to Hawkish Fed Has Two Explanations

18 June 2017

Upbeat US economic numbers gave investors reason to hope that the Federal Reserve will stick with its plan to hike rate, which put pressure on the rupee.

The dollar index, which measures the United States currency's strength against major currencies, was trading at 96.985, up 0.01% from its previous close of 96.975.

Earlier Thursday, the U.K. Office for National Statistics said retail sales fell 1.2% in May, compared to expectations for a 0.8% fall.

The U.S. yield curve flattened, with the difference between short-dated two-year Treasury yields and benchmark 10-year yields narrowing to a difference of 78.58 basis points US2US10=RR, the smallest since September 9."It just looks like the Fed is sticking to their story and the market remains highly skeptical that the Fed is going to be able to deliver just based upon underlying data".

United States consumer prices slowed further than expected in May.

The US dollar also hit its highest against the euro, Swiss franc and Swedish crown since May 30 following the data releases.

The widely expected quarter-point interest rate hike will take the Fed funds target rate above 1 percent for the first time since the immediate aftermath of the collapse of Lehman Brothers in 2008. They fell as low as 2.103 percent following the downbeat data, their lowest since November 10.

Mexico's central bank is likely to raise interest rates next week to contain a spike in inflation and following a move by the U.S.

The Fed said it expects US inflation to be at 1.7 percent by the end of this year, down from the 1.9 percent previously forecast. The rest of them said it would make such a move at its December 12-13 meeting.

Once the Fed starts to normalize its balance sheet, the impact could remain minimal as the Fed plans to offload $6 billion in US Treasuries each month.

Indeed, the flattening of the yield curve, a line that traces yields across maturities, over the course of the week indicates that "the market and the Fed are not on the same page", said Ward McCarthy, chief financial economist at Jefferies, in a note to clients.

At the same time, the world's most important central bank also normalized money printing - a policy instrument that nearly a decade ago was introduced as an extraordinary, emergency, one-off response to the huge credit crunch that threatened to engulf the world economy.

BOJ Governor Haruhiko Kuroda is also seen dispelling market speculation that the central bank is engaging in "stealth tapering" by stressing that the recent slowdown in its Japanese government bond buying is simply the result of a stable bond market, according to sources familiar with the BOJ's thinking.

The dollar index fell on Wednesday to its lowest level since October 2016 after a slew of disappointing data: consumer prices fell more than expected and retail sales disappointed in May.

But the New Zealand dollar skidded 0.8 percent to $0.7213, moving away from the previous session's four-month high of $0.7319.