This is not the first article on the FED, and it won’t be the last. We have equated FED talk to “beating the dead horse” since we basically have been waiting for the FOMC to officially put the nail in the coffin of the Great Recession and signal that we have “officially recovered” by greenlighting an interest rate hike. Pundits have been reporting every angle they can on the FED story to grab headlines. Some say that the FED has missed the “window,” that the world can’t survive a hike, or if the FED doesn’t raise rates as promised before the end of 2015 the FOMC and Janet Yellen will lose all credibility and it will mark the end of the United States reign of world economic dominance. You name the story; however extreme or tame it maybe after years of near zero rates it has likely been told. The story is not what SHOULD the FED do, the story is what happens when the FED does what it does.
The federal funds futures market is currently discounting a 74% chance that the FOMC will announce a +25 bp rate hike to a new funds rate target range of 0.25-0.50% with a mid-point of 0.375%. The markets certainly will not be surprised by a rate hike and indeed there may be some sell-the-rumor buy-the-fact effect in the stock market after a rate hike announcement. If you are sports fans you will know that upsets happen all the time (unless you are a Cubs fan), but the message is clear that the market expects a rate hike. We are not going to touch that “dead horse” if a hike is right or wrong, but if the FED does NOT hike it would upset as many brackets as a #16 seed knocking off a mighty #1 seed in the NCAA basketball tournament (though it would not be as mind blowing as the Cubs actually winning the World Series).
With a 74% chance of a hike, a raise is already priced into the bond market, the currency market, and the equity markets around the world. Politics aside the “market” does not want the FED to rise with a few exceptions such as in industries like banking or individual companies that will also be able pocket additional profits from a stronger dollar. Once the FED does lift off though it will be a confirmation that the domestic economy is actually healthy and marks an end to the long-dark last seven years since the Great Recession. Though a hike is expected and it should be taken as a sign of a healthy economy, it does not mean that a hike may not cause some sell-offs, after all 26% of the market is still calling the FED’s bluff and realizes that the global economy has some serious concerns.
But the key for how the markets react in the wake of a FED rate hike decision will be how the FED will word its new interest rate guidance. Based on the current yield curves the market currently does not fully expect the next 25 bp rate hike until July 2016. The markets will be looking for some language that effectively guarantees that the FED’s schedule will be “slow” as they have repeatedly said. Even if they hike as expected but omit language of the pace, or the market gets a feeling that the FED could take a more aggressive path, then the hike would likely strike fear and spook the markets.
Regardless if we see market rallies or if we see sell-offs and weakness around a rate hike, the downside risk is if the FED does NOT increase rates on Wednesday.
Shares in developing nations are heading for the longest slump since June and their currencies are sliding, while European stocks are at a two-month low and oil is at is at the lowest level in seven years. Emerging-market equities are getting bashed as higher U.S. rates will trigger outflows from riskier assets.
These moves are what is happening in expectation of a hike, but what happens if the FED does NOT hike? Will everything reverse and things get bright and rosy? NO!
What do we say all the time? Markets HATE uncertainty, and if the FED does not increase rates world markets are going to have to scramble to figure out their next moves to stimulate their economics to keep pace with the dollar and longer periods of uncertainty as they have to wait even longer on the FED.
“Investors are clearly finding it harder to read central banks,” said Mansoor Mohiuddin, senior markets strategist at Royal Bank of Scotland Group Plc in Singapore. “Central banks are all hoping the Fed’s imminent tightening will weaken their domestic currencies against the greenback, so they’re holding back on meeting the market’s expectations for further easing.”
So if the FED does not raise rates, governments’ around the world will be forced to find ways to devalue their currency which will force traders, corporations, and borrowers to unwind positions which can lead to panic and trigger defaults. Remember that the whole reason we are having this discussion about increasing rates is because rate had to do to zero after the Financial Crisis which was largely triggered by Lehman Brothers, and that taught us that it does not take much to cause a major chain reaction of events that can snowball out of control.
Currency bears were caught on the losing side as the Euro surged 3.1% on December 3rd after the European Central Bank’s quantitative-easing overhaul and deposit-rate cut fell short of what some investors had predicted. Draghi repeatedly hinted about more easing in the run-up to the gathering, prompting hedge funds and speculators to push bets on a weaker euro.
The unwinding of 74% of all positions that are expecting a rate hike would make the 3.1% Euro move look like child’s play compared with rapid moves in currencies around the world should the FED not hike.
No need to be afraid of credit markets, currency markets, and global response to a FOMC rate hike, be afraid of how credit markets, currency markets, and the globe responds if the FED does NOT hike rates. At the end of the day if the Fed hikes and the world cannot handle a quarter point, then there are problems far greater than any rate policy can handle. If the FED stays steady and does not hike it will send and even worse message that there are real problems we should be afraid of if America and the globe is not healthy enough to handle what should be an insignificant quarter point move that has already been priced into the market.