Fed de­ci­sion plunges bourses into the red

Financial Mirror (Cyprus) - - FRONT PAGE -

The Fed de­ci­sion fol­low­ing the Septem­ber 16-17 FOMC meet­ing was ex­pected by some, and roundly crit­i­cised by many oth­ers. Whether or not the de­ci­sion was the cor­rect one has to be viewed in con­text of the larger global pic­ture. That the Fed de­ci­sion is sup­posed to take US do­mes­tic eco­nomic con­di­tions into ac­count was put aside in this par­tic­u­lar in­stance as a re­sult of global eco­nomic weak­ness. The In­ter­na­tional Mon­e­tary Fund (IMF) cau­tioned cen­tral banks around the world not to raise in­ter­est rates at this crit­i­cal junc­ture. Mas­sive un­cer­tainty re­mains fol­low­ing the eq­ui­ties melt­down in China, where tril­lions of dol­lars was wiped off the Shang­hai Com­pos­ite in­dex and the Shen­zhen In­dex in Au­gust. This plunged Euro­pean and Amer­i­can bourses into a tail­spin, and the cur­rent mar­ket predica­ment is best de­scribed as pre­car­i­ous.

The 12 mem­ber FOMC and Board of Gover­nors at the Fed­eral Re­serve de­cided al­most unan­i­mously (with one dis­sent­ing voice) to adopt a dovish tone and stick with the short-term in­ter­est rate at cur­rent lev­els 0%-0.25%. This has far-reach­ing im­pli­ca­tions for mar­ket sen­ti­ment, and mul­ti­ple as­set cat­e­gories which will be im­pacted by the de­ci­sion.

Fol­low­ing the Fed de­ci­sion an­nounce­ment on Thurs­day, Septem­ber 17, US in­dices plunged. This seems coun­ter­in­tu­itive given that eq­ui­ties mar­kets in the US should em­brace low in­ter­est rates. Had there been a rate hike, the cost of bor­rowed money would have in­creased, lead­ing to sharp declines in com­pany prof­its, earn­ings per share and div­i­dends paid out to share­hold­ers. This did not hap­pen, yet eq­ui­ties mar­kets plunged. The rea­son­ing be­hind the sharp sell-off in US eq­ui­ties is per­haps best ex­plained by the ex­pec­ta­tions of stake­hold­ers in the mar­ket.

The big­gest losers on Wall Street were banks, fi­nan­cial in­sti­tu­tions, as­set man­agers and the like. They were ex­pect­ing wind­fall prof­its from their cus­tomers and in­vestors in the event that the Fed hiked in­ter­est rates by the an­tic­i­pated 0.25%. Had this hap­pened, bil­lions upon bil­lions of dol­lars in added rev­enue streams would have been gen­er­ated by banks, with more in­ter­est earned on mort­gages, long-term loans, credit fa­cil­i­ties, etc. As a re­sult of no changes be­ing made, sharp sell­offs in this sec­tor took place, and dragged down the Dow Jones, NAS­DAQ and the S&P 500. The S&P 500 dropped 1.6% to 1,958.03, the Dow Jones dropped 1.7% to 16,384.58 and the NAS­DAQ com­pos­ite in­dex dropped 1.4% to 4,827.23. Re­mem­ber that banks and fi­nan­cial in­sti­tu­tions com­prise a large per­cent­age of the over­all value of Wall Street bourses.

Be­sides the IMF cau­tion­ing against a rate hike, the Fed was more con­cerned with two im­por­tant el­e­ments:

- US core in­fla­tion is cur­rently 1.2% and the Fed is tar­get­ing an in­fla­tion rate of 2% be­fore it hikes in­ter­est rates;

- Global weak­ness con­tin­ues to dom­i­nate, led by sharp con­trac­tions in the per­for­mance of the Chi­nese econ­omy.

That the Fed is con­cerned about the state of Chi­nese stock mar­kets, and the Chi­nese econ­omy at large is es­pe­cially no­table. What many an­a­lysts con­sid­ered to be a re­gion­spe­cific prob­lem is now be­ing viewed as an is­sue that has the po­ten­tial to up­set the global eco­nomic bal­ance. In other words, the prob­lem in China has to be con­tained and no­body wants to cre­ate greater un­cer­tainty by rais­ing in­ter­est rates at this time.

Here’s what would have hap­pened had the Fed raised in­ter­est rates. The USD would be­come more de­sir­able vis-avis a bas­ket of cur­ren­cies. This would strengthen the dol­lar and weaken cur­ren­cies that were be­ing traded for the dol­lar. Ul­ti­mately, this de­ci­sion would hurt US ex­ports, which would lead to con­trac­tions in US eco­nomic per­for­mance over the long-term. While a strong US dol­lar al­lows the US to pur­chase more for­eign goods and ser­vices, this would up­set the bal­ance of trade and be detri­men­tal to US eco­nomic growth.

Another is­sue is that of emerg­ing mar­ket cur­ren­cies. Cap­i­tal flight con­tin­ues to leave Brazil, Rus­sia, China, In­dia and South Africa en masse. The de­ci­sion not to hike in­ter­est rates ini­tially led to a strength­en­ing of emerg­ing mar­ket cur­ren­cies, but all gains were given back as anx­i­ety re­turned to the spec­u­la­tive mar­ket. The Fed did not rule out a rate hike in Oc­to­ber, Novem­ber or De­cem­ber. There­fore, emerg­ing mar­ket coun­tries have won the bat­tle, but not the war. Spec­u­la­tors have cap­i­talised on this per­va­sive anx­i­ety among traders, send­ing cur­ren­cies like the South African Rand, Turk­ish lira, the Brazil­ian real and oth­ers into a down­ward spi­ral.

Dur­ing times of mar­ket un­cer­tainty, the one as­set class that al­ways ben­e­fits is gold. And this is pre­cisely what hap­pened in the run-up to the Fed de­ci­sion and in post de­ci­sion ac­tiv­ity. As men­tioned, eq­ui­ties should rally when in­ter­est rates are low, but they didn’t in this case. The rea­son is that there is tremen­dous un­cer­tainty in the mar­kets es­pe­cially now that the Fed was un­able to make a do­mes­tic de­ci­sion be­cause of weak­ness in China. This shows that US stock mar­kets are more vul­ner­a­ble than what many traders and in­vestors be­lieved.

No­body wants to plough money into the eq­ui­tiy mar­kets if they think that in­ter­est rates are go­ing to rise within the next cou­ple of months. Gold is a non-in­ter­est-bear­ing as­set. This pre­cious me­tal, along with plat­inum and sil­ver, spiked fol­low­ing the Fed de­ci­sion. Gold for de­liv­ery in De­cem­ber in­creased by 1.9% to $1137.80 per ounce, and the weekly gain in the pre­cious me­tal was 3.1%. Re­mem­ber that the de­mand for gold is in­versely re­lated to the strength of the dol­lar. An in­ter­est-rate hike would strengthen the USD and send gold reel­ing. Now you’re likely to see a mini rally in the price of gold, but large sell­offs will pos­si­bly take place closer to the next Fed pol­icy meet­ing.

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