Last updated: May 3rd, 2017 at 09:58 pm
At 1900BST tonight the Federal Reserve will announce its latest monetary policy decision. For weeks now the debate has raged in the media and the analyst community as to whether the Fed will or even should (two different questions) raise interest rates in the US for the first time in nine years. Today we finally get the answer. What will be the impact on financial markets? I look at three potential scenarios.
Firstly let me lay out my view quickly.
I believe that the process of normalisation needs to begin. The growth and level of unemployment in the labor market both point towards a rate hike, but I am firmly of the belief that if the Fed do not move soon (September or December) then they could struggle to move at all. The Fed needs the tools to be able to react once the next recession (possibly induced by faltering global growth driven by the China/Emerging Markets slowdown) comes around (which it will inevitably do at some stage. By starting to raise rates, the signal that the Fed would send out to investors would be that the US is ready to move away from the emergency ultra-low interest rate environment that it has been in since the 2008 global financial crisis.
However, the Fed remains dovish in its outlook and is cautious to say the least. The latest FOMC minutes suggested that continued improvement in the labor market was needed and also confidence that inflation was beginning to move towards its 2% target (as part of its dual mandate). All inflation data remains stagnant with the Fed’s preferred Personal Consumption Expenditure data falling on a core basis last month and remaining on a downward trajectory. The voting make up set out in the table below suggests that there needs to be a significant shift in the opinions of several members of the FOMC to exact a change of policy. It would need all four centrists plus Jeffrey Lacker to vote for a hike (to make 5) and then one of the doves to completely change sides. (This table comes courtesy of Reuters). Whether this is likely is a serious question as it would involve a serious shift in policy thinking on the committee. With the market turmoil driven by falling commodities and a China slowdown which have really hit in the past few weeks, this would be a brave step to take for an inherently dovish FOMC.
So then, lets look at the various scenarios of monetary policy decisions and their respective impacts on financial markets:
So, scenario 1, the Fed not changing its monetary policy seems to be the most likely, with Fed Funds futures pricing in around 30% chance of a hike today. Although I see volatility as likely in whatever decision is made, this would be the low volatility event. This would be dollar negative and is likely to result in further gains on EUR/USD above the initial resistance at $1.1370 and up towards the old range high from $1.1465. Similarly with Cable, as sterling has strengthened in the past few days, a dovish Fed would drive GBP/USD through $1.5530 and towards the old resistance band $1.5690. I would see that the ranges would continue though. As for gold, the rally from yesterday would be likely to continue towards the key resistance band $1132/$1147 but once again I would see it as a chance to sell as gold remains in a long term bear market. As for equity markets, there is likely to be an extension of the recent rally which is resulting in the S&P 500 breaking out of its recent range above 1993, whilst for European markets expect the DAX to put pressure back towards resistance at 10,513 and the FTSE 100 breaking above 6285.
For scenario 2, the hawkish scenario where the Fed hikes rates by 25 basis points would be bullish for the dollar and Treasury yields. The key move on EUR/USD would be the pivot level between $1.1050/$1.1100 which is currently just over 200 pips lower. This is likely to be tested and probably ultimately broken in due course. Cable is a harder one to predict as I see the Bank of England as in a position to be able to mirror the Fed’s actions now (UK wages again improving yesterday). So, I would see the $1.5330 support band being tested initially and the bottom of the key medium term range at $1.5170 could also come under pressure, however I do not believe that it would be broken (at least not for long anyway). Gold would come under big pressure again and the bear market move would kick back in again and the recent low at $1098 would be tested initially before a likely retest of the July/August $1080 key lows. As for equity markets there is likely to be an initial downside reaction but I think that a look at the US 10 year Treasury yield needs to be made to determine the ongoing impact on equity markets. If the yield on longer dated Treasuries does not push too far higher this may reflect the bond markets suggesting the Fed is making a mistake which would impact on future growth (which would be a negative pull on equities). In this scenario there could be a retest of the big August lows then.
Scenario 3 is a difficult call. As the Fed could temper concerns over a rate hike by either making a 10 basis point hike (or maybe 12.5bps) which would suggest that normalisation has begun but in a gradual manner; or do a 25 basis point hike with a big shallowing of the dot plots. This would help to settle concerns over a rate hike as it is the path/speed of rate rises that is important rather than the act of raising rates itself. Either way the initial move on the market will be to strengthen the US dollar and sell equities, but then the risk off move could be limited and perhaps the market would even be buoyed by this once the dust begins to settle. In this we may see EUR/USD coming back towards $1.1100 and bouncing, GBP/USD bouncing off $1.5330 support, Gold back around $1100, whilst equity markets could find themselves bouncing in a volatile range rather than trending lower.
As I said before, I think that scenario 1 is the most likely, whilst if the Fed does hike, I think that it will be intent on making sure that the market knows that the normalisation process will be long and the terminal rate will be low. I still believe that the Fed will pass up the opportunity today, with Janet Yellen guiding for a rate hike by the end of the year (i.e. in December) in her FOMC pres conference. The band wagon will roll on, but at least with a little more certainty.
At Hantec Markets Ltd we provide an execution only service. Any opinions expressed by analyst Richard Perry should not be construed as investment advice or an investment recommendation. This report does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions.