Why are interest rates so important to traders?
There was much talk of a September rise in US interest rates. This likelihood may have receded following Monday’s events on global exchanges, but a change in policy will still be a major event when it finally comes. So why do interest rates matter so much and how do traders work with them?
Market not yet ready for Fed rate hike
I’m going to go out on a limb and say that the probability of a rate hike in September is unlikely. Prior to Friday 21 August, I may have been more inclined to argue in favour of a rate hike, but recent events have put paid to that notion. The massive sell-offs in Chinese, European and US equities have likely put talk of a rate hike on ice – for now.
What we are seeing taking place is a market correction. It’s nowhere near the market crash of 1987 when 22% (or 508 points) was wiped off the Dow Jones Industrial Average in a single day of trading. Ironically that day lives on in infamy as Black Monday and, while the Dow initially plunged over 1000 points on Monday 24 August, it then recovered somewhat to trade around 16,000 points – down 2.77% by mid-morning.
Whatever the full impact of Monday’s crisis may be, the long-term prospects for equities markets are clearly on the downturn now. We have seen trillions of dollars wiped off global bourses owing to weakness in China, and this storm is just getting started.
How likely is a rate hike now?
If we go on the minutes from the last Fed meeting on July 28 to 29, we can be confident that the likelihood of a rate hike is slim-to-none for September. Just one member of the committee voted in favour of a hike but others are of the opinion that weak inflation remains a concern.
In order for a rate hike to be implemented, the US economy must show clear signs of strength and robustness. In this respect we may say that the US economy is fundamentally and structurally sound, but the global commodities meltdown, a strong US dollar and plunging equities prices will all give pause to talk of an imminent rate hike.
When interest rates rise, equities lose favour for several reasons. For starters, the long-term debt that companies have will increase and that will diminish returns on stocks (lower prices, lower dividends, lower corporate profits, layoffs etc), and this will be reflected in equity prices. With equities markets undergoing shocks of late, the last thing the Fed will want to do is rock the boat any further.
How about inflation and unemployment?
The targeted US inflation rate is 2%. The unemployment rate is 5.3%. It is clear from the FOMC July meeting that the US was on track to hit its targets, but it has not quite reached that point. During July, prices rose 0.1%, which marks a 0.2% increase year-on-year. There is no doubt that China is the elephant in the room. With trillions of dollars wiped off the Chinese stock market in recent days, there is deep concern that even Chinese government intervention will be unable to stop the bleeding.
Traders are looking for signs from the Fed about which way rates will go. But the more procrastination and uncertainty there is, the higher the volatility in the markets. A rate hike would be bad for the gold price, since gold is a non-interest-bearing commodity. If the rate hike occurs, put options on gold are the right course of action. The more likely scenario is a rate hike in the next couple of months – possibly December. It’s a numbers game, but the numbers don’t quite add up just yet.
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