The most important FOMC meeting of the year is now upon us and as we head into this crucial decision, opinions and forecasts are still widely split over which way the Fed is going to go. Some players are expecting the Fed to raise interest rates for the first time since 2006, others are calling for the Fed to remain on hold and to move at the December meeting whilst some see the Fed holding off until next year. With such polarity in forecasts evident among the industry, it is clear that the Fed has a very difficult call to make.
Lets summarise some of the key arguments both for and against the Federal Reserve raising rates tomorrow.
Issues Supporting An Interest Rate Increase
- Interest rates are incredibly low and have been for a long time. The Fed has declared its desire to lift rates sooner rather than later to allow for a more gradual increase in rates fearing that if it does not raise rates soon, the first increase will need to be steeper than 0025bps which would have a greater impact on markets.
- Many feel that the lingering uncertainty over the timing of a Fed lift-off is more damaging than the potential situation post-lift-off and the central banks of both India and Mexico have called for the Fed to raise rates to put an end to the uncertainty weighing on emerging markets.
- Low interest rates for too long a period does not support growth and productivity, as seen in Japan which has suffered a sprawling recession throughout the course of it’s ultra-loose monetary policy.
- Employment has picked up steadily with the unemployment rate back down to 5.1%, the lowest it has been since 2008 and back down to levels that the FOMC deems consistent with “full-employment”
- Although inflation is weak, the Fed insists this is due to transitory factors (energy and commodity price declines) and will rebound in the near future.
- Monetary policy works with a lag and the Fed has to make policy changes with a 6-12 month future economic situation in mind not necessarily just the current economic situation. The declining level of “slack” in the US economy suggests that inflation will indeed pick up.
Issues Against An Interest Rate Increase
- Many argue that Emerging Market economies are not yet in a place where they can withstand the capital outflows that could ensue should th Fed raise rates. As a great deal of businesses in these economies also hold significant USD denominated debt, these debts will increase as USD interest rates increase undermining growth in these economies.
- Although labour market conditions have improved, the inflation environment poses a significant risk. Over the last year whilst the Fed has been labelling the oil and commodity price declines “transitory effects”, they have in fact continued to decline. Goldman Sachs put out a piece this week saying that oil could go as low as $20 a barrel. If these markets do continue to decline they will weigh heavily on inflation.
- The global risk environment is not supportive of an increase in rates. Volatility stemming from the slowdown in China has proven to be a critical risk to markets and with such volatility already present, the Fed would be unwise to risk exacerbating this with a rate increase.
- Economic data, although much improved in some areas is still not fully indicative of a solid recovery and combined with the low inflationary environment suggests that the economy is not yet at the point where a rate increase is required. With other central banks locked firmly in easing cycles and global risks and inflationary pressures weigh, there have been some comments that suggest the Fed would be better easing rather tightening at this stage.
It is particularly difficult to gauge this decision. The fact that global risk sentiment is so delicate currently and the inflation environment being so low does seem to suggest that these aren’t optimal conditions for hiking, but again, the Fed has stated it wishes to raise sooner rather than later so as to avoid a steeper lift-off which would surely have a bigger impact on markets and so perhaps raising now and getting it over with would be the best option.
In considering potential trade options it is prudent to consider the outcomes of some recent episodes of Fed tightening.
Past Lift-Off Dates
In 1994 and 2004 the Fed raised rates after extended periods of low or declining interest rates. 1997 & 199 saw the Fed increase rates during periods of already high interest rates. So what were the outcomes of these interest rate increases?
In April 94 USD traded lower following lift-off with losses extending as US fundamentals began to weaken shortly after lift-off, prompting markets to fear that the Fed’s tightening would derail the US economic recovery.
In March ’97 the Fed raised rates at a time when the USD was one of the G10’s highest yielding currencies. USD gained steadily throughout the rest of the year fuelled mainly by the risk-off environment driven by the Asian financial crisis of Summer ’97.
In June ’99 the Fed again raised rates during a period of already high rates. USD suffered in the months following the lift-off though it regained positive ground into year end and continued to trade higher during 2000.
In June ’04 the Fed raised rates and again USD sold off following the lift-off remaining weak throughout the rest of the year amid growing concerns over the path of the US economy with national debt increasing rapidly and export income undershooting import expenditure.
The response to the start of these tightening cycles is notable as three of the four lift-off’s saw USD weaken. Only in the wake of the Asian financial crisis of ’97 did USD experience broad gains following lift-off. USD Long positioning is down sharply from the levels we saw earlier in the year when there was talk of the Fed moving in June and so there is plenty of room for upside USD engagement. However, it could be that the reason positioning was decreases was precisely because of the chance of a June rate hike and the knowledge that the USD doesn’t tend to experience broad gains following a lift-off but indeed does much better in the run up to the lift-off.
Fed Raises Rates
If the Fed does in fact raise rates tomorrow we can expect the USD to appreciate against risk-correlated currencies. With risk-appetite already so fragile, the potential for further risk-off flows on the back of any volatility expose risk-currencies to downside whilst suggesting that safe haven currencies could gain in the wake of a lift-off.
In terms of best expressions of initial USD strength, NZDUSD seems a strong candidate. The material weakness in the New Zealand economy, such that the RBNZ has stated the likley need for further easing, highlights a path of least resistance for the US Dollar. NZDUSD is currently towards the lower end of a multi-year channel and as such we can expect a lift-off to push NZDUSD down into a test of the channel low at around 0.58 where we should see strong demand kick-in.
Look to trade short targeting a move into this level or alternatively buy a test of the channel low.
With the potential for a US lift-off to damage global risk-appetite JPY should strengthen based on safe-haven inflows. Currently stalled at the long term descending trend line and a retest of the the ascending trend line from the 1990 low, USDJPY has room to correct lower back into support around the key psychological 100 mark.
Should spot begin to trade lower confirming a medium term top in USDJPY, I would use retracements on the Daily & H4 time frames to set shorts targeting a move back into 100 where we should find strong support.
Fed Holds Rates Unchanged But Keeps December On The Table
If the Fed maintains rates at this meeting but uses language to highlight that economic conditions are improving and that it expects global risks and downward inflationary pressures to subside into year end then I would be expecting some USD fall off in the short-term but would use that to gain better entry into some longer term positions.
AUDUSD would likely see a sharp relief rally if the Fed maintains rates, however I would look to sell into any AUDUSD strength. The RBA maintained rates at their last meeting in lieu of an anticipated increase by the Fed. If this increase doesn’t materialise, the RBA will once again need to adjust their monetary policy to address weakness in the Australian economy. Coupled with a potential December lift off by the Fed, an AUDUSD short seems an attractive position play.
If AUDUSD spikes higher into a retest of the descending channel line, or beyond and into a retest of the broken consolidation formed over January – June this year, these would appear decent areas to set shorts.
Fed Holds Rates Unchanged And Sounds Unconvincing Over A December Lift Off
Should the Fed maintain rates tomorrow and sound decidedly Dovish in it’s interest rate forecasts then we may initially see EURUSD higher in the short term in response to this outcome, with global equity markets avoiding the prospect of a post-lift off world and risk sentiment likely benefiting similarly. However EUR would once again see it’s funding status utilized. The ECB are still on course to expand their QE program and should inflation conditions worsen, expect both their verbal and actual intervention to increase, dragging EURUSD lower.
If EURUSD spikes higher into channel resistance and the 38.2% retracement from the 2014 sell off against the 2005 lows around 1.18, this seems a good area to look for price action to confirm short entries. Alternatively a move higher would see a retest of the broken ascending trend line and 50% retracement from 2014 highs around 1.22 which ultimately should prove to be the end to any upside correction in EURUSD