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The US Rate Decision - What Every Trader Should Know
On Wednesday the 16th of December, the FOMC will conclude a 2 day meeting in which it will decide on raising US interest rates for the first time in a decade. In September we looked at a market that was pricing only a small chance of a rate increase, with declines in energy prices and a weak global outlook weighing heavily on the minds of FOMC members.
In this updated paper we re-examine the landscape and market expectations for the forthcoming meeting, contrasting this to the September meeting when the FOMC decided not to proceed with raising interest rates.
When the Federal Reserve does finally increase their interest rate target, this event is likely to be one of the largest to impact financial markets in the last decade and the ramifications in currency, stock and bond markets is expected to be dramatic.
The announcement is heavily anticipated -meaning a shock impact on the day may be unlikely, however the event may mark a turning point in the post-GFC recovery and a shift in to a new phase in markets; with the direction and magnitude of asset price moves quite uncertain and the duration and severity of the tightening cycle still an unknown.
Traders should be aware that the potential for market volatility is high, and price movements could be well outside of usual daily trading ranges should the FOMC make any surprise decision. We hope that this paper can help prepare traders for some of the possible outcomes, and have a better understanding of the situation overall.
We break down the article in to four parts:
1. An Introduction to the Event – What is this about and when can I expect it?
2. The Current State of the US Economy – Is the economy ready for higher rates?
3. Expected Market Implications – What markets are expected to be most impacted?
4. Possible Surprise Reactions – How the market might get caught off guard
An Introduction to the Event:
It is unusual for a 25 basis point interest rate increase to generate as much interest as has been seen in the lead up to the December FOMC meeting. However, the US economy is not a normal economy – it is the largest, most important for financial markets and policy changes there tend to have spill over effects worldwide. Consensus for when the Fed will move rates has shifted continuously on fluctuations in employment, inflation and commodity prices.
The effects of the 2014/2015 commodity price collapse and rapid US dollar appreciation have weighed on some sectors of the economy such as energy and exports, but strong performance in other sectors has meant the economy has bounced back strongly. While it seemed touch-and-go for the Fed to raise interest rates in September – with the market only pricing a 23% chance of a rate rise- the markets have come to a calmer resolve that the Fed is likely to move soon regardless of a few lingering doubts – with rate markets now pricing a convincing probability of around 80% that the change finally takes place in December.
When the September meeting proved to be too bold a time for the FOMC to move, the focal point of markets shifted all the way to the December 16th meeting - where the policy decision and press conference will be held from 21:00 server time, along with the committee’s updated inflation and growth forecasts for the next two years.
Markets have now almost fully priced the first hike at the December meeting, with economists in agreement that the Fed should make a move this month - the divergence between the two from the September meeting has dissipated, giving the FOMC confidence that they will no longer be surprising markets by following through with this policy change.
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The FOMC will also update their projections of expected interest rates and inflation, though this time the changes may only be minor as the intensity of the energy price collapse have lessened of late – with a base effect in energy prices likely to prevent any large further declines in inflation for now.
The Current State of the US Economy:
The largest hurdle the Fed has faced in having a green light to raise interest rates is that CPI inflation is still bordering on deflation - as it has held at around the 0% for much of this year. The Fed has a target inflation rate of 2%, and although core CPI and other smoothed measures are holding up better by filtering out energy price declines, it is not an easy sell to raise interest rates while inflation is near its GFC lows.
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Market based measures of inflation expectations – derived from bond yields – have stabilised since September.
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Indications from Yellen and other FOMC members are that they have confidence that this deflationary energy shock is transient and may even provide stimulus to consumers; when the one-off falls in oil prices have filtered through the year-on-year figures, things will begin to look healthier for inflation measures.
Oil prices first reached the low $40’s per barrel level in early 2015, so barring another major leg down in prices (which some major investment banks have forecast) this could see the price declines pass through year-on-year inflation in the first half of 2016 – allowing for a recovery towards target from mid-2016 onwards.
When looking at inflation figures, the Fed tries to look ahead by around 12-18 months – which is the time many believe it takes for monetary policy to begin to work on the economy. Because of this time consideration, the FOMC are willing to ignore or look through the low inflation seen today, as long as they are ‘reasonably confident’ that inflation will begin to return to target over the next 1-2 years.
Another consideration that the FOMC have to make is around the pace of tightening, which may be affected by the start date for lift-off. Previously, Janet Yellen has indicated that a gradual rise in rates is preferred, implying an earlier first hike and a gentle pace of increases so as not to shock markets too much.
The reason for caution here is that if the Fed instead waits until inflation has returned to target, or overshoots it to the upside, then they may be forced to raise rates rapidly to prevent inflation getting out of hand – having the potential to cause a large amount of financial stress and another credit crunch. FOMC member Eric Rosengren suggested in a speech in September that the FOMC expects tightening to occur at around half the pace of the previous cycle in 2004, which may mean a rate increase at every second meeting.
The second part of the Federal Reserve’s dual mandate is to promote maximum employment; on this measure the Fed is already fairly successful, with the unemployment rate now back to what it considers a natural rate of unemployment – where cyclical factors have been largely eliminated. As of the last reading this month, unemployment is back to 5.0% and the CBO’s long term natural rate of unemployment is estimated to be approximately 5% - using these measures the employment recovery appears to be complete.
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With Friday’s strong headline jobs figure of 211,000 jobs added, most economists now consider that the FOMC has a green light to raise rates. Previous FOMC statements had indicated that one remaining factor that they were intent on seeing before the first policy tightening was ‘some further improvement in the labour market’; with the Unemployment Rate back to full employment and strong NFP numbers each month, the stage appears set for a rate increase.
Yellen indicated this month that that the US economy probably needs less than 100,000 jobs added per month to sustain the current level of employment and absorb new entrants to the labour force, so the current rate of recovery appears healthy enough to withstand some tightening.
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A point that will give the FOMC confidence to raise interest rates is that, as the slack in the labour market has been taken up and the economy is near full capacity, wage pressures will begin to grow in the labour market to help support inflation’s return to target.
Wage growth has been fairly anaemic since the GFC, which may be partially explained by wages being ‘sticky’ downwards – meaning that employers are reluctant or unable to cut wages by as much as may be warranted under the economic circumstances – causing an additional slack in wage pressures that needs to be taken up; wage pressures and inflation may have been further delayed by the need for the difference between nominal wages and the true value of labour to be absorbed. Wages data since the September meeting has suggested that wage growth may finally overcome this barrier, with year on year increases of 2.3% in the most recent report.
Other measures of economic health seem to indicate that the US economy is reasonably healthy. GDP growth and cyclical measures such as industrial production are holding up despite scepticism about the upcoming tightening. Real GDP growth is now comfortably in the 2-3 percent range which, while not booming, is a fairly healthy rate of growth.
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If FOMC members are correct in their belief that inflation will return to trend, then most measures of the real economy would give them a green light to go ahead. What is still very much up in the air is how markets will handle the tightening cycle. Stock markets have benefited from an era of very accommodative policy that has allowed price-earnings multiples to climb in recent years; whether the removal of this accommodation will take the wind out of the stock market’s sails is something that is in the front of many investor’s minds.
Expected Market Implications:
The expected effects of a US tightening cycle are already evident in various pockets of the global economy including declining commodity prices, financial stress in emerging markets, US dollar strength and increasing market volatility.
Expectations are that, should the Federal Reserve continue to tighten in the current environment, stress will continue to build in these other parts of the world even as the US economy powers forward. While so many markets are affected by the Federal Reserve’s policies, the central bank may not be able to ignore its own domestic situation in order to make things easier for foreign economies.
In a situation where the Fed embarks on a tightening cycle out of step with a sluggish global economy, the divergence in economic prospects could continue to heavily affect economies tied to commodities and those who have borrowed in US Dollars.
Countries that utilise a pegged exchange rate may also face pressure to devalue if the US Dollar continues to strengthen. China, who runs a loose peg to the US dollar, may be forced to devalue further and break its strong ties to the dollar in order to tend to its own economy.
Not only this, but China’s recent inclusion to the SDR (Special Drawing Rights) basket means that it is expected to allow market forces to have a larger input to the Yuan’s value – with many betting on a devaluation as large as 10%.
A weakened Yuan could depress Chinese commodity demand from external sources even further, which could be another hit in a long line of disappointments for emerging markets. One consequence of this currency weakening and liberalisation could also be for China to offload its foreign exchange reserves to slow the Yuan’s decent to a manageable rate – reducing its reserve buffer against a currency crisis in the future and possibly exerting a small upward pressure on US bond yields.
The Kingdom of Saudi Arabia (KSA) also runs a currency peg of the Riyal to the US dollar, which has served them well as they accumulated petrodollars as a result of their surplus oil production. However, with OPEC yet again failing to come to an agreement on reducing production during its meeting this month, the oil market looks set to continue in a state of supply glut – depressing revenues for the Saudi government and causing internal pressures for the oil exporting economy.
As the Riyal is tied directly to the US dollar, domestic costs rise at a time when oil prices decline – meaning the currency peg is pro-cyclical rather than acting as an automatic stabiliser like a floating exchange rate.
Since implementing its policy to flood the oil market, FX reserves for the KSA have been declining noticeably due to the lower oil revenue and need to defend the value of the Riyal; should this continue, the KSA could see a messy devaluation once its reserves are exhausted. Absent any natural recovery in oil prices from cuts in the rest of the world, there are two main ways for the Saudi government to deal with the issue:
Cut oil production and restore order to the oil market. Saudi crude production was actually increased into the already oversupplied crude market this year – exceeding OPEC quotas - with many believing it to be an attempt to weed out shale producers in the US and defend market share.
However, the play appears to have at least partially backfired as US production has maintained around the same level a lot longer than some might have expected; this has been bleeding the KSA government of its normal oil revenues, which would be far higher under a slight production cut and the resulting higher oil prices.
A production cut by OPEC would be the easiest way for the KSA to deal with its domestic and currency issues, though it could lose face on the global stage.
De-peg the Riyal. This would be very difficult to implement and as emerging markets have shown in the past, the volatility and turmoil involved can often be very disruptive and create a crisis in confidence and in economic terms.
A rapid devaluation can quickly increase inflation as the price of imported goods increases, leading to a need to raise interest rates and a tightening of financial conditions. This would not be an easy option to implement.
With these possibilities in mind, it is easy to envisage of a feedback loop that sees emerging markets in particular facing terrible economic pain, and pegged currencies being forced in to new mechanisms.
Commodity price declines could further depress emerging market economies and exacerbate currency weakness against the US dollar; if those economies have large exposure to US Dollar denominated debt, then funding issues could be the next domino. In the past when the value of foreign debt service increases with the exchange rate, emerging markets have typically run in to debt or currency crises.
The situation could be a cornucopia of economic malaise, before even considering that some of these economies could also have potential housing bubbles – such as commodity exporters Canada and Australia.
Possible Surprise Reactions:
With most people being aware of the potential dangers of this tightening cycle outlined above, we feel it may be more interesting to think about what some scenarios where the hype surrounding the event may have caused some to overestimate the effects of a US tightening. Here are some contrarian scenarios to balance out the debate:
Surprise 1: The market reacts in a risk off manner, but the US Dollar is not the chosen safe haven:
People might still be scratching their heads as to why the US dollar sold off from August 19th to the 25th, in tandem with stock markets worldwide.
Again on the 3rd of December, when Mario Draghi disappointed markets by announcing an underwhelming stimulus expansion, the USD sold off rapidly at the same time as markets plummeted. In both cases, it seemed almost as if the US was no longer the safe haven of choice as it has been for much of the time since the onset of the GFC. One theory to explain this unexpected move is that of the transition between how the US dollar – and indeed the Euro and Yen – are seen as funding currencies.
Through the wake of the GFC, when the US held rates at zero and performed multiple rounds of quantitative easing, the US Dollar became a ‘funding currency’ for risk positions or carry trades; funding costs were low and expectations were that the US dollar would continue to weaken against stronger economies currencies.
As US prospects have improved over the last two years, sentiment has shifted positively towards the country - even more so now that the country is expected to enter a tightening phase – and use of the US Dollar as a funding currency is considered to be a much riskier proposition.
At the same time, across the Pacific, Japan was moving the Yen deeper in to its place as a funding currency; ‘Abenomics’ saw the country embark on a very large scale program of Quantitative Easing - which would then be expanded in October 2014 – leading to a persistent currency depreciation.
Across the Atlantic, Europe was putting together the makings of an asset purchase program and another series of LTRO programs to stimulate the economic bloc. As one of the easing measures, the ECB also moved interest rates in to negative territory for the first time – and again with another 10 basis point cut this month, it has all but cemented the Euro as a funding currency for risk positions due to a low cost of funding.
The Swiss Franc finds itself in a similar position now that interest rates are also firmly negative at -0.75%, though with the dramatic moves in the Franc this year the currency has been treated with more caution than the other two.
A funding currency will often lose value during good times as risk positions build up using the currency as the source of funding – traders are short the funding currency and long risk assets; this is commonly known as a carry trade in FX, and it has the unfortunate consequence of unwinding rapidly when market sentiment turns sour – similar to how margin debt is rapidly reduced when the stock market crashes.
Interestingly, despite the US economy being generally considered the economy with stronger economic prospects, unwinding risk positions can mean that currencies such as the Euro, Yen and Swiss Franc act as the stronger safe havens.
Given this explanation, it is no surprise that the August and smaller December stock market crashes were accompanied by strength in these currencies and a substantial ‘short squeeze’ of the positions built up in the US dollar. The Dollar found itself part of a broader group of risk currencies that sold off heavily, in a reaction that caused much surprise.
A tightening cycle should theoretically move the US Dollar further away from a position as a funding currency. Most recently on the 3rd of December, the US dollar fell in lock-step with stock markets, then recovered as indices bounced back:
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The surprise reaction in this scenario is that the rate hike is taken by the market in a risk-off manner, causing a stock market selloff in the US as well as abroad. If the new paradigm of the Euro and Yen as funding currencies holds firm, then a stock market rout could actually see a surprise appreciation in these two currencies and a mixed or negative reaction for the US Dollar. With US Dollar positioning at extreme levels this could be quite explosive.
To some extent this reaction depends on how dependent market valuations are on monetary policy, or how risk sentiment reacts to monetary policy. In some prior cycles, the stock market been driven by strong economic growth – the horse (economy) pulling the cart (stock market).
Sometimes it is sentiment that pulls the market higher, or even the market gains themselves that encourage further speculation. One example of this would be the 1990’s tech boom, where much of the gain was price-earnings multiple expansion rather than purely earnings growth; in this situation it is the cart (stock market) pulling the horse (economy) whether it chooses to follow or not. Was quantitative easing and ZIRP the market’s good news story, or was the strong rebound in the economy the main driver of the markets?
Surprise 2: The big question – is it already priced in?
So often in markets when everyone expects one thing to happen, the opposite occurs. Markets are constantly surprised when the obvious is suddenly so obviously wrong. The old adage of “Buy the rumour, sell the fact” so often rings true. Examples of this litter the recent past, can you remember what you were thinking would happen next in the lead-up to the major announcements below?
Quantitative Easing: The general consensus from analysts and economists was that long term interest rates were going to fall when QE started due to the Federal Reserve buying such large quantities of bonds. When the programs started, yields jumped higher in a counterintuitive reaction (red), but began mysteriously dropping each time the Federal Reserve stopped buying bonds and exited the market (blue):
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Tapering: in a similar vein, when QE ended there were fears that the lack of demand for bonds would see yields rise and cause trouble in loan markets and for US debt service. Surprisingly, yields fell quite consistently from the moment the Fed tapered, and continued falling even after it completed the tapering process (yellow, above).
QE 2: When QE 2 was to be announced, there were expectations that it would cause another period of US dollar weakness and it was often regarded as ‘printing money’. In another counterintuitive move, the dollar sold off against currencies like the Euro right up to the day of the announcement, and then without obvious reason reversed course and strengthened for months afterwards:
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European QE: As recently as this year, there was near consensus that it was a matter of when, not if, the Euro would plummet past parity with the US Dollar as the market built up expectations for a QE program from the ECB. Negative sentiment towards the Euro reached fever pitch in March this year, when QE finally began and the ECB began creating Euros to buy up assets.
After falling for the first couple of days of the program, the Euro has been remarkably resilient since QE started, and even an expansion of QE and additional rate cut has failed to move the currency below parity with the dollar:
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The problem is likely that, in most of these cases, the market had already priced in the effects of the monetary policy change before it began. Once the policy changes were announced this signalled the end of the journey for a lot of traders, and their positions being closed out caused a counterintuitive market reaction. The question of how much of the tightening cycle is priced in will be at the forefront of many trader’s minds when it comes to the FOMC announcement.
Surprise 3: A Dovish Hike:
Mario Draghi showed traders last week that expectations matter when it comes to a news release – if the market overestimates how a central bank will act, a counterintuitive reaction can occur as traders trim back their bets on the announcement. The Euro rallied 500 pips last Thursday after the ECB’s new easing measures did not meet expectations - despite fresh cuts in the deposit rate to -0.3%.
A dovish hike for the FOMC would be one that satisfies the market’s expectations of a 25 basis point increase, but talks down the pace of further increases either in the FOMC Statement or the press conference that follows.
A dovish statement might take the stance that any further rate increases are data dependent, and that the FOMC will raise gradually to ensure that the economy is not slowing as a result of normalisation – this could also be accompanied by a sentence about a wait-and-see approach towards the next rate hike, where the FOMC takes a period of assessment before moving again.
The overall impact of any move by the FOMC will be quite large, but much of the immediate impact should be relatively muted by the long lead-up to the announcement – in which time markets have digested and prepared for the change.
So while a surprise reaction could occur if the decision is delayed, FOMC members have spent the last few months trying to ensure that they do not surprise markets with forward guidance and massaging expectations – a decision to move ahead with the rate rise should not in itself cause any major shock to markets. We hope this guide has helped provide some insight in to why the Fed may move at this meeting, and some potential risks of a market surprise.
Remember, you are a risk manager first and a trader second. When you know the charts like the back of your hand, it’s much easier to exist comfortably in both of these roles.
The US Rate Decision - What Every Trader Should Know
On Wednesday the 16th of December, the FOMC will conclude a 2 day meeting in which it will decide on raising US interest rates for the first time in a decade. In September we looked at a market that was pricing only a small chance of a rate increase, with declines in energy prices and a weak global outlook weighing heavily on the minds of FOMC members.
In this updated paper we re-examine the landscape and market expectations for the forthcoming meeting, contrasting this to the September meeting when the FOMC decided not to proceed with raising interest rates.
When the Federal Reserve does finally increase their interest rate target, this event is likely to be one of the largest to impact financial markets in the last decade and the ramifications in currency, stock and bond markets is expected to be dramatic.
The announcement is heavily anticipated -meaning a shock impact on the day may be unlikely, however the event may mark a turning point in the post-GFC recovery and a shift in to a new phase in markets; with the direction and magnitude of asset price moves quite uncertain and the duration and severity of the tightening cycle still an unknown.
Traders should be aware that the potential for market volatility is high, and price movements could be well outside of usual daily trading ranges should the FOMC make any surprise decision. We hope that this paper can help prepare traders for some of the possible outcomes, and have a better understanding of the situation overall.
We break down the article in to four parts:
1. An Introduction to the Event – What is this about and when can I expect it?
2. The Current State of the US Economy – Is the economy ready for higher rates?
3. Expected Market Implications – What markets are expected to be most impacted?
4. Possible Surprise Reactions – How the market might get caught off guard
An Introduction to the Event:
It is unusual for a 25 basis point interest rate increase to generate as much interest as has been seen in the lead up to the December FOMC meeting. However, the US economy is not a normal economy – it is the largest, most important for financial markets and policy changes there tend to have spill over effects worldwide. Consensus for when the Fed will move rates has shifted continuously on fluctuations in employment, inflation and commodity prices.
The effects of the 2014/2015 commodity price collapse and rapid US dollar appreciation have weighed on some sectors of the economy such as energy and exports, but strong performance in other sectors has meant the economy has bounced back strongly. While it seemed touch-and-go for the Fed to raise interest rates in September – with the market only pricing a 23% chance of a rate rise- the markets have come to a calmer resolve that the Fed is likely to move soon regardless of a few lingering doubts – with rate markets now pricing a convincing probability of around 80% that the change finally takes place in December.
When the September meeting proved to be too bold a time for the FOMC to move, the focal point of markets shifted all the way to the December 16th meeting - where the policy decision and press conference will be held from 21:00 server time, along with the committee’s updated inflation and growth forecasts for the next two years.
Markets have now almost fully priced the first hike at the December meeting, with economists in agreement that the Fed should make a move this month - the divergence between the two from the September meeting has dissipated, giving the FOMC confidence that they will no longer be surprising markets by following through with this policy change.
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The FOMC will also update their projections of expected interest rates and inflation, though this time the changes may only be minor as the intensity of the energy price collapse have lessened of late – with a base effect in energy prices likely to prevent any large further declines in inflation for now.
The Current State of the US Economy:
The largest hurdle the Fed has faced in having a green light to raise interest rates is that CPI inflation is still bordering on deflation - as it has held at around the 0% for much of this year. The Fed has a target inflation rate of 2%, and although core CPI and other smoothed measures are holding up better by filtering out energy price declines, it is not an easy sell to raise interest rates while inflation is near its GFC lows.
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Market based measures of inflation expectations – derived from bond yields – have stabilised since September.
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Indications from Yellen and other FOMC members are that they have confidence that this deflationary energy shock is transient and may even provide stimulus to consumers; when the one-off falls in oil prices have filtered through the year-on-year figures, things will begin to look healthier for inflation measures.
Oil prices first reached the low $40’s per barrel level in early 2015, so barring another major leg down in prices (which some major investment banks have forecast) this could see the price declines pass through year-on-year inflation in the first half of 2016 – allowing for a recovery towards target from mid-2016 onwards.
When looking at inflation figures, the Fed tries to look ahead by around 12-18 months – which is the time many believe it takes for monetary policy to begin to work on the economy. Because of this time consideration, the FOMC are willing to ignore or look through the low inflation seen today, as long as they are ‘reasonably confident’ that inflation will begin to return to target over the next 1-2 years.
Another consideration that the FOMC have to make is around the pace of tightening, which may be affected by the start date for lift-off. Previously, Janet Yellen has indicated that a gradual rise in rates is preferred, implying an earlier first hike and a gentle pace of increases so as not to shock markets too much.
The reason for caution here is that if the Fed instead waits until inflation has returned to target, or overshoots it to the upside, then they may be forced to raise rates rapidly to prevent inflation getting out of hand – having the potential to cause a large amount of financial stress and another credit crunch. FOMC member Eric Rosengren suggested in a speech in September that the FOMC expects tightening to occur at around half the pace of the previous cycle in 2004, which may mean a rate increase at every second meeting.
The second part of the Federal Reserve’s dual mandate is to promote maximum employment; on this measure the Fed is already fairly successful, with the unemployment rate now back to what it considers a natural rate of unemployment – where cyclical factors have been largely eliminated. As of the last reading this month, unemployment is back to 5.0% and the CBO’s long term natural rate of unemployment is estimated to be approximately 5% - using these measures the employment recovery appears to be complete.
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With Friday’s strong headline jobs figure of 211,000 jobs added, most economists now consider that the FOMC has a green light to raise rates. Previous FOMC statements had indicated that one remaining factor that they were intent on seeing before the first policy tightening was ‘some further improvement in the labour market’; with the Unemployment Rate back to full employment and strong NFP numbers each month, the stage appears set for a rate increase.
Yellen indicated this month that that the US economy probably needs less than 100,000 jobs added per month to sustain the current level of employment and absorb new entrants to the labour force, so the current rate of recovery appears healthy enough to withstand some tightening.
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A point that will give the FOMC confidence to raise interest rates is that, as the slack in the labour market has been taken up and the economy is near full capacity, wage pressures will begin to grow in the labour market to help support inflation’s return to target.
Wage growth has been fairly anaemic since the GFC, which may be partially explained by wages being ‘sticky’ downwards – meaning that employers are reluctant or unable to cut wages by as much as may be warranted under the economic circumstances – causing an additional slack in wage pressures that needs to be taken up; wage pressures and inflation may have been further delayed by the need for the difference between nominal wages and the true value of labour to be absorbed. Wages data since the September meeting has suggested that wage growth may finally overcome this barrier, with year on year increases of 2.3% in the most recent report.
Other measures of economic health seem to indicate that the US economy is reasonably healthy. GDP growth and cyclical measures such as industrial production are holding up despite scepticism about the upcoming tightening. Real GDP growth is now comfortably in the 2-3 percent range which, while not booming, is a fairly healthy rate of growth.
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If FOMC members are correct in their belief that inflation will return to trend, then most measures of the real economy would give them a green light to go ahead. What is still very much up in the air is how markets will handle the tightening cycle. Stock markets have benefited from an era of very accommodative policy that has allowed price-earnings multiples to climb in recent years; whether the removal of this accommodation will take the wind out of the stock market’s sails is something that is in the front of many investor’s minds.
Expected Market Implications:
The expected effects of a US tightening cycle are already evident in various pockets of the global economy including declining commodity prices, financial stress in emerging markets, US dollar strength and increasing market volatility.
Expectations are that, should the Federal Reserve continue to tighten in the current environment, stress will continue to build in these other parts of the world even as the US economy powers forward. While so many markets are affected by the Federal Reserve’s policies, the central bank may not be able to ignore its own domestic situation in order to make things easier for foreign economies.
In a situation where the Fed embarks on a tightening cycle out of step with a sluggish global economy, the divergence in economic prospects could continue to heavily affect economies tied to commodities and those who have borrowed in US Dollars.
Countries that utilise a pegged exchange rate may also face pressure to devalue if the US Dollar continues to strengthen. China, who runs a loose peg to the US dollar, may be forced to devalue further and break its strong ties to the dollar in order to tend to its own economy.
Not only this, but China’s recent inclusion to the SDR (Special Drawing Rights) basket means that it is expected to allow market forces to have a larger input to the Yuan’s value – with many betting on a devaluation as large as 10%.
A weakened Yuan could depress Chinese commodity demand from external sources even further, which could be another hit in a long line of disappointments for emerging markets. One consequence of this currency weakening and liberalisation could also be for China to offload its foreign exchange reserves to slow the Yuan’s decent to a manageable rate – reducing its reserve buffer against a currency crisis in the future and possibly exerting a small upward pressure on US bond yields.
The Kingdom of Saudi Arabia (KSA) also runs a currency peg of the Riyal to the US dollar, which has served them well as they accumulated petrodollars as a result of their surplus oil production. However, with OPEC yet again failing to come to an agreement on reducing production during its meeting this month, the oil market looks set to continue in a state of supply glut – depressing revenues for the Saudi government and causing internal pressures for the oil exporting economy.
As the Riyal is tied directly to the US dollar, domestic costs rise at a time when oil prices decline – meaning the currency peg is pro-cyclical rather than acting as an automatic stabiliser like a floating exchange rate.
Since implementing its policy to flood the oil market, FX reserves for the KSA have been declining noticeably due to the lower oil revenue and need to defend the value of the Riyal; should this continue, the KSA could see a messy devaluation once its reserves are exhausted. Absent any natural recovery in oil prices from cuts in the rest of the world, there are two main ways for the Saudi government to deal with the issue:
Cut oil production and restore order to the oil market. Saudi crude production was actually increased into the already oversupplied crude market this year – exceeding OPEC quotas - with many believing it to be an attempt to weed out shale producers in the US and defend market share.
However, the play appears to have at least partially backfired as US production has maintained around the same level a lot longer than some might have expected; this has been bleeding the KSA government of its normal oil revenues, which would be far higher under a slight production cut and the resulting higher oil prices.
A production cut by OPEC would be the easiest way for the KSA to deal with its domestic and currency issues, though it could lose face on the global stage.
De-peg the Riyal. This would be very difficult to implement and as emerging markets have shown in the past, the volatility and turmoil involved can often be very disruptive and create a crisis in confidence and in economic terms.
A rapid devaluation can quickly increase inflation as the price of imported goods increases, leading to a need to raise interest rates and a tightening of financial conditions. This would not be an easy option to implement.
With these possibilities in mind, it is easy to envisage of a feedback loop that sees emerging markets in particular facing terrible economic pain, and pegged currencies being forced in to new mechanisms.
Commodity price declines could further depress emerging market economies and exacerbate currency weakness against the US dollar; if those economies have large exposure to US Dollar denominated debt, then funding issues could be the next domino. In the past when the value of foreign debt service increases with the exchange rate, emerging markets have typically run in to debt or currency crises.
The situation could be a cornucopia of economic malaise, before even considering that some of these economies could also have potential housing bubbles – such as commodity exporters Canada and Australia.
Possible Surprise Reactions:
With most people being aware of the potential dangers of this tightening cycle outlined above, we feel it may be more interesting to think about what some scenarios where the hype surrounding the event may have caused some to overestimate the effects of a US tightening. Here are some contrarian scenarios to balance out the debate:
Surprise 1: The market reacts in a risk off manner, but the US Dollar is not the chosen safe haven:
People might still be scratching their heads as to why the US dollar sold off from August 19th to the 25th, in tandem with stock markets worldwide.
Again on the 3rd of December, when Mario Draghi disappointed markets by announcing an underwhelming stimulus expansion, the USD sold off rapidly at the same time as markets plummeted. In both cases, it seemed almost as if the US was no longer the safe haven of choice as it has been for much of the time since the onset of the GFC. One theory to explain this unexpected move is that of the transition between how the US dollar – and indeed the Euro and Yen – are seen as funding currencies.
Through the wake of the GFC, when the US held rates at zero and performed multiple rounds of quantitative easing, the US Dollar became a ‘funding currency’ for risk positions or carry trades; funding costs were low and expectations were that the US dollar would continue to weaken against stronger economies currencies.
As US prospects have improved over the last two years, sentiment has shifted positively towards the country - even more so now that the country is expected to enter a tightening phase – and use of the US Dollar as a funding currency is considered to be a much riskier proposition.
At the same time, across the Pacific, Japan was moving the Yen deeper in to its place as a funding currency; ‘Abenomics’ saw the country embark on a very large scale program of Quantitative Easing - which would then be expanded in October 2014 – leading to a persistent currency depreciation.
Across the Atlantic, Europe was putting together the makings of an asset purchase program and another series of LTRO programs to stimulate the economic bloc. As one of the easing measures, the ECB also moved interest rates in to negative territory for the first time – and again with another 10 basis point cut this month, it has all but cemented the Euro as a funding currency for risk positions due to a low cost of funding.
The Swiss Franc finds itself in a similar position now that interest rates are also firmly negative at -0.75%, though with the dramatic moves in the Franc this year the currency has been treated with more caution than the other two.
A funding currency will often lose value during good times as risk positions build up using the currency as the source of funding – traders are short the funding currency and long risk assets; this is commonly known as a carry trade in FX, and it has the unfortunate consequence of unwinding rapidly when market sentiment turns sour – similar to how margin debt is rapidly reduced when the stock market crashes.
Interestingly, despite the US economy being generally considered the economy with stronger economic prospects, unwinding risk positions can mean that currencies such as the Euro, Yen and Swiss Franc act as the stronger safe havens.
Given this explanation, it is no surprise that the August and smaller December stock market crashes were accompanied by strength in these currencies and a substantial ‘short squeeze’ of the positions built up in the US dollar. The Dollar found itself part of a broader group of risk currencies that sold off heavily, in a reaction that caused much surprise.
A tightening cycle should theoretically move the US Dollar further away from a position as a funding currency. Most recently on the 3rd of December, the US dollar fell in lock-step with stock markets, then recovered as indices bounced back:
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The surprise reaction in this scenario is that the rate hike is taken by the market in a risk-off manner, causing a stock market selloff in the US as well as abroad. If the new paradigm of the Euro and Yen as funding currencies holds firm, then a stock market rout could actually see a surprise appreciation in these two currencies and a mixed or negative reaction for the US Dollar. With US Dollar positioning at extreme levels this could be quite explosive.
To some extent this reaction depends on how dependent market valuations are on monetary policy, or how risk sentiment reacts to monetary policy. In some prior cycles, the stock market been driven by strong economic growth – the horse (economy) pulling the cart (stock market).
Sometimes it is sentiment that pulls the market higher, or even the market gains themselves that encourage further speculation. One example of this would be the 1990’s tech boom, where much of the gain was price-earnings multiple expansion rather than purely earnings growth; in this situation it is the cart (stock market) pulling the horse (economy) whether it chooses to follow or not. Was quantitative easing and ZIRP the market’s good news story, or was the strong rebound in the economy the main driver of the markets?
Surprise 2: The big question – is it already priced in?
So often in markets when everyone expects one thing to happen, the opposite occurs. Markets are constantly surprised when the obvious is suddenly so obviously wrong. The old adage of “Buy the rumour, sell the fact” so often rings true. Examples of this litter the recent past, can you remember what you were thinking would happen next in the lead-up to the major announcements below?
Quantitative Easing: The general consensus from analysts and economists was that long term interest rates were going to fall when QE started due to the Federal Reserve buying such large quantities of bonds. When the programs started, yields jumped higher in a counterintuitive reaction (red), but began mysteriously dropping each time the Federal Reserve stopped buying bonds and exited the market (blue):
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Tapering: in a similar vein, when QE ended there were fears that the lack of demand for bonds would see yields rise and cause trouble in loan markets and for US debt service. Surprisingly, yields fell quite consistently from the moment the Fed tapered, and continued falling even after it completed the tapering process (yellow, above).
QE 2: When QE 2 was to be announced, there were expectations that it would cause another period of US dollar weakness and it was often regarded as ‘printing money’. In another counterintuitive move, the dollar sold off against currencies like the Euro right up to the day of the announcement, and then without obvious reason reversed course and strengthened for months afterwards:
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European QE: As recently as this year, there was near consensus that it was a matter of when, not if, the Euro would plummet past parity with the US Dollar as the market built up expectations for a QE program from the ECB. Negative sentiment towards the Euro reached fever pitch in March this year, when QE finally began and the ECB began creating Euros to buy up assets.
After falling for the first couple of days of the program, the Euro has been remarkably resilient since QE started, and even an expansion of QE and additional rate cut has failed to move the currency below parity with the dollar:
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The problem is likely that, in most of these cases, the market had already priced in the effects of the monetary policy change before it began. Once the policy changes were announced this signalled the end of the journey for a lot of traders, and their positions being closed out caused a counterintuitive market reaction. The question of how much of the tightening cycle is priced in will be at the forefront of many trader’s minds when it comes to the FOMC announcement.
Surprise 3: A Dovish Hike:
Mario Draghi showed traders last week that expectations matter when it comes to a news release – if the market overestimates how a central bank will act, a counterintuitive reaction can occur as traders trim back their bets on the announcement. The Euro rallied 500 pips last Thursday after the ECB’s new easing measures did not meet expectations - despite fresh cuts in the deposit rate to -0.3%.
A dovish hike for the FOMC would be one that satisfies the market’s expectations of a 25 basis point increase, but talks down the pace of further increases either in the FOMC Statement or the press conference that follows.
A dovish statement might take the stance that any further rate increases are data dependent, and that the FOMC will raise gradually to ensure that the economy is not slowing as a result of normalisation – this could also be accompanied by a sentence about a wait-and-see approach towards the next rate hike, where the FOMC takes a period of assessment before moving again.
The overall impact of any move by the FOMC will be quite large, but much of the immediate impact should be relatively muted by the long lead-up to the announcement – in which time markets have digested and prepared for the change.
So while a surprise reaction could occur if the decision is delayed, FOMC members have spent the last few months trying to ensure that they do not surprise markets with forward guidance and massaging expectations – a decision to move ahead with the rate rise should not in itself cause any major shock to markets. We hope this guide has helped provide some insight in to why the Fed may move at this meeting, and some potential risks of a market surprise.
Remember, you are a risk manager first and a trader second. When you know the charts like the back of your hand, it’s much easier to exist comfortably in both of these roles.
