D-Day has come for the Fed rate hike

Financial Mirror (Cyprus) - - FRONT PAGE -

Global an­a­lysts are go­ing to be glued to eco­nomic in­di­ca­tors in the run-up to the Septem­ber 16-17 Fed FOMC meet­ing. What is be­ing billed as pos­si­bly the most im­por­tant eco­nomic an­nounce­ment out of the US for the year has pun­dits split down the mid­dle. The is­sue of course is whether or not the Fed will hike in­ter­est rates from their present rate at 0.25%. Fed­eral Re­serve Bank chair­per­son Janet Yellen has not given any­thing sub­stan­tive away in the lead up to the pol­icy de­ci­sion this week. How­ever, sen­ti­ment ex­pressed by the vice-chair­man Stan­ley Fis­cher in­di­cates there is a pos­si­bil­ity of a rate hike this time around.

The pre­car­i­ous predica­ment of global fi­nan­cial mar­kets is some­thing that has ev­ery­body con­cerned. The Chi­nese eq­ui­ties melt­down in Au­gust saw a dra­matic de­cline in China’s for­eign cur­rency re­serves of $93.9 bln. As China at­tempted to prop up the yuan by selling USD and buy­ing CNY, cur­rency traders and an­a­lysts con­tem­plated the im­pact of such mea­sures.

It is clear that there are struc­tural cracks in the Chi­nese econ­omy, and this ex­tends well be­yond the re­cent slump in eq­ui­ties prices. Tril­lions of dol­lars have been wiped off global mar­kets since Chi­nese de­mand de­clined. We are also see­ing plung­ing prices in energy stocks, min­ing stocks and re­lated com­modi­ties as a re­sult of weak­ness in the world’s sec­ond­largest econ­omy.

It is against this back­drop that Fed pol­i­cy­mak­ers must come to a de­ci­sion re­gard­ing US in­ter­est rates. Typ­i­cally the Fed de­ci­sion does not take the state of the global econ­omy into mind when mak­ing a do­mes­tic in­ter­est-rate de­ci­sion. How­ever in this par­tic­u­lar in­stance, there is way too much in­sta­bil­ity ow­ing to the in­ter­con­nect­ed­ness of global mar­kets. Ev­ery­one around the world is talk­ing about the Fed rate hike.

On Thurs­day, the US cen­tral bank will make its an­nounce­ment af­ter a 2-day meet­ing of pol­i­cy­mak­ers. Presently, the sta­tis­tics sug­gest that there is a 28% like­li­hood that the Fed will raise its lend­ing rate from 0.25% to 0.5%. If this hap­pens, it will be the first such rate in­crease in seven years. Econ­o­mists how­ever are more op­ti­mistic than gen­eral mar­ket sen­ti­ment sug­gests – and they are evenly split on the like­li­hood of a rate hike.

There are sev­eral fac­tors that point to a rate hike be­ing a real pos­si­bil­ity. For ex­am­ple, the US PMI fig­ures for man­u­fac­tur­ing and ser­vices are all pos­i­tive and ex­pan­sion­ary. Any­thing over 50 is re­garded as a grow­ing econ­omy, and any­thing un­der 50 is re­garded as a con­trac­tionary econ­omy. It should be pointed out that China’s PMI num­bers are hov­er­ing around 47-48 and that is clearly a sign of a con­trac­tionary man­u­fac­tur­ing sec­tor.

The fact that the US num­bers are pos­i­tive, al­beit de­clin­ing over time, sug­gests that it is the bet­ter per­form­ing econ­omy in many ways. Stan­ley Fis­cher and Janet Yellen are tar­get­ing an in­fla­tion rate of 2%, and while that fig­ure has not yet been reached it is not be­ing billed as a pre­req­ui­site for a rate hike. There are po­ten­tial pit­falls to in­creas­ing in­ter­est rates in the US, and these are be­ing care­fully weighed in the run-up to the de­ci­sion.

For ex­am­ple, a rate hike has the ef­fect of mak­ing the cost of bor­rowed money more ex­pen­sive. It also places an ad­di­tional bur­den on com­pa­nies that have long-term debts, short-term debts or other long-term loans obli­ga­tions. This eats into the earn­ings per share fig­ures and com­pany prof­itabil­ity which ul­ti­mately drives the com­pany stock price down on the Dow Jones or the NAS­DAQ. For these rea­sons, a rate hike has a con­trac­tionary ef­fect on stock mar­kets, but it will cer­tainly boost dol­lar de­mand in the short term. At a ba­sic level, rate hikes make it more ex­pen­sive for home­own­ers to take out mort­gages, and it also makes credit card re­pay­ments that much more ex­pen­sive.

There are sev­eral in­di­ca­tors that show a Fed rate hike is likely, in­clud­ing the in­crease in the US dol­lar in­dex from a level of 90 to a level of 95. This in­di­cates not only that the dol­lar is strength­en­ing against a bas­ket of cur­ren­cies, but that the US econ­omy over­all is in good stand­ing. We must bear in mind that the In­ter­na­tional Mon­e­tary Fund has cau­tioned cen­tral banks against rais­ing in­ter­est rates for fear that it will de­rail the re­cov­ery of the global econ­omy. The Fed is likely to take that into con­sid­er­a­tion at the 2-day meet­ing this week.

How­ever it should not be for­got­ten that mar­kets do not typ­i­cally re­act com­pletely once an eco­nomic an­nounce­ment has been made. These types of de­ci­sions and the ac­tions that sur­round them are fac­tored into mar­ket ac­tiv­ity long be­fore the an­nounce­ment it­self is made. We can­not dis­count the fact that high lev­els of volatil­ity have been driv­ing mar­kets lately, and a Fed hike would fi­nally put paid to all the un­cer­tainty that is swirling around. As a re­sult, re­lief ral­lies may take place and eq­ui­ties may in fact re­verse their down­ward trend. And with China slow­ing down, the world will now be look­ing to the #1 econ­omy – the US – to lead by ex­am­ple. A Fed rate hike is the clear­est such in­di­ca­tor that the US econ­omy is sound!

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