If a Fed rate hike is now a formality how will the markets react?
Today and tomorrow the FOMC is evaluating recent US economic data and determining whether the time is right for the first rate hike in nine years. The overwhelming consensus among analysts, economists and speculators is that the Fed will move to hike rates by 0.25%, bringing the interest rate to 0.50%. This has far-reaching implications for the US economy, emerging markets and currency exchange rates.
There are several potential scenarios, if we assume the full impact of a rate hike has not yet been factored into the markets:
- A rate hike could lead to a spike in demand for the US dollar and decline in demand for emerging market currencies (South African rand, Turkish lira, Brazilian real, Russian ruble, Indian rupee, etc). With EM currencies already at their nadir, this could prove devastating to their economies moving into 2016.
- We could see continued capital flight from developing countries like Russia, Zambia, Nigeria, South Africa, Venezuela and Brazil, since investment in these countries is perceived as volatile and risky.
- A rate hike may cause a shift in investor expectations away from equities to fixed income-bearing investments such as Treasuries, bonds, certificates of deposit and savings accounts. Equities tend to languish when interest rates rise, owing to the increased cost of borrowing which has the effect of decreasing the profits of listed companies.
- The world’s foremost safe haven asset – gold – could retreat in price as a Fed rate hike takes effect. Gold demand tends to move in the opposite direction to the US dollar, and a rate hike would potentially strengthen the dollar. Gold also does not earn interest – so it loses favour.
- Short to medium term, a rate hike will make US-produced goods more expensive on international markets. This will diminish the profitability of US corporations as exports shrink. It will however make imports more affordable for US consumers.
- A stronger US dollar affects dollar-denominated commodities such as gold, crude oil, iron ore, copper and the like, and could result in a restriction of demand.
There are of course other possible effects of a Fed rate hike, and many analysts are of the opinion that these effects have already taken place. For example, if we look at the currencies of emerging market economies such as South Africa, it is clear that the anxiety and volatility leading up to the rate hike has already been woven into the exchange rates. According to these analysts is now merely a matter of confirming what the market has already accepted as holy writ: a rate hike is a foregone conclusion.
Indeed the Fed chair, Janet Yellen, has intimated in the clearest possible terms that the US economy has sufficiently recovered, and is performing as expected to warrant a rate hike. The unemployment rate has fallen to 5%, the October and November nonfarm payrolls have been impressive, consumer sentiment is positive, manufacturing and services PMI data is positive, and the China equities rout and global commodities weakness have not had the detrimental effect on the US economy that many pundits thought they would.
In other words, the US economy is ripe for a rate hike and this will help to achieve the Fed’s inflation target of 2%.
Deeper implications of a Fed rate hike
The likelihood of a rate hike is now 75%, which means three-quarters of all analysts are expecting the Fed to raise interest rates on December 16. A gentle rise of a quarter percent would ease concerns but also potentially herald a new sequence of steadily increasing interest rates affecting homeowners and others borrowing money (auto loans, credit card loans, long-term debt).
One may ask why a rate hike would come into effect in the first place? Well, if another recession comes the Fed will want to have room to manoeuvre. With interest rates as low as they are, there is nowhere to move at present.
However, the Fed typically raises interest rates when ISM orders near 60, but presently they are around 48. We should also bear in mind that US equities markets have typically performed negatively for at least two quarters following a rate hike.
What about homeowners?
It’s hard to get excited about a Fed rate hike when the cost of credit is going to increase. This is especially true for homeowners. Most Americans do not feel the recession is over – with 72% of respondents in a Public Religion Research Institute Poll indicating they feel worse off, and a Harvard Institute of Politics poll finding that about 50% of American millennials believe their prospects of success are dead. Even Gallup found that the number of Americans who now consider themselves middle class has declined from 61% to 51%.
This sentiment is clearly evident with homeowners associations which have not seen a groundswell of interest in new home purchases or applications for mortgages. For example the National Association of Home Builders in Illinois has been building homes at a rate of 6000 per annum, down from 35,000 per annum in 2005.
Quite simply, for many American the funds to make a down payment are unavailable. Will a Fed rate hike improve the prospects of saving money for these aspiring homeowners? It seems a long shot given the realities on the ground. As is often the case, what seems good from the macroeconomic perspective might not immediately benefit the individual.
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