Fed is set to take a hawkish turn - ING

"Markets may have shrugged off the upcoming change at the top of the Fed, but they remain complacent about the risks of faster rate rises next year," notes James Knightley, Chief International Economist at ING.

Key quotes

Markets are too complacent on rate hikes.

After weeks of twists and turns, markets breathed a sigh of relief as President Trump opted for continuity in his nomination of Jerome Powell for Fed Chair. The fact that Trump opted for a "gradualist" on interest rates, rather than the potentially more hawkish Taylor or Warsh, has contributed to the Treasury curve flattening to its lowest in 10 years.

However, we feel the market is being too complacent. The combination of upside risks to growth and mounting inflationary pressures, as well as a hawkish rotation in the make-up of Fed voters, suggests that markets are too cautious in only pricing in one hike next year. We expect two, with risks of more rather than fewer.

Some scepticism is understandable.

Assuming Yellen decides to stand down completely when her Fed Chair term ends in February, four out of the seven positions on the Federal Reserve Board will be vacant. There is also now a vacancy at the New York Fed, given that its President, William Dudley, is retiring early. Remember the NY Fed is particularly involved in the financial market aspects of monetary policy, as well as its President having a permanent vote on interest rates.

As with the Fed Chair, Trump has the choice over who fills the four board member vacancies. Given he is facing mid-term elections in a year's time, it is unlikely he'll want to see clear hawks appointed that could threaten his three percent growth target.

But until Trump has made his decisions and the full 2018 voter mix becomes clear, it is perhaps not surprising that markets continue to treat the Fed's latest "dot diagram" cautiously. Some scepticism is also understandable given the Fed has signalled higher rates before in its dots, without ultimately following through. And on the face of it at least, below-target core inflation and October's weak wage growth number suggests there's no pressing need for a more aggressive shift towards policy tightening in the near term.

The Fed is set to take a hawkish turn.

Then there's the annual rotation of voters at the Fed. This will see arch-dove Neel Kashkari leave, along with Charles Evans (who isn't far behind on the dovish scale). They'll be replaced by the more hawkish John Williams and Loretta Mester. Williams is in favour of three hikes next year, and Mester has even hinted she'd like the Fed to go 'a little stronger' than that.

Until Trump gets new governors onto the Fed board, this means the group of voters will be both smaller and more hawkish, faced with an economy that is performing well and that may have more fuel thrown on the fire with tax cuts.

We're expecting a December rate hike, and these various factors mean there is upside risk to our call for two further rate rises next year. What's more, the long-end of the curve will also have to deal with additional supply from the Fed's balance sheet reduction programme.