FED UP WITH Us INTEREST RATES? Will the US Federal Reserve hike interest rates in 2015, and what effect would this have on the fledgling US economic recovery and the financial markets? Authors: Kathleen Brooks, Matt Weller and Fawad Razaqzada
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions. Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan. Please read Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp).
Introduction: After seven years of US interest rates remaining close to 0%, the Federal Reserve is thinking about hiking interest rates. Federal Reserve Vice Chairman William Dudley said that he hopes interest rates will rise in the US this year. This is worth noting since Dudley is considered one of the most dovish (i.e., less likely to vote for a rate hike) members on the FOMC. After so many years of zero-bound rates, the prospect of a rate hike could be disruptive for financial markets; however, the most disruption may be caused not by the timing of the first rate hike from the Fed, but by the pace of hikes going forward. While we expect a rate hike at some stage in the second half of this year, we are less concerned with the actual date of the first rate hike and more focused on the pace of tightening. Will the Federal Reserve embark on a traditional rate-hiking cycle, or will it hike rates on a more ad hoc basis? Federal Reserve Chair Janet Yellen has sought to ease market and economic fears about higher interest rates in the US by saying that any rate-hiking cycle will be slow and dependent on the performance of the US economy. Such an on/off approach to rate hikes would be a break from the traditional cycle of hikes in the past. This new approach to normalising monetary policy could impact financial markets in a different way compared to previous rate-hiking cycles. In this report we will discuss: • • •
The potential timing of the first rate hike What a rate-hiking cycle could look like Potential market implications
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1, The Potential Timing of the First Rate Hike The Federal Reserve has a dual mandate: full employment and a 2% inflation target. Although the Fed has hinted at the prospect of a rate hike this year, the timing is still unknown. A weak patch in economic data since the start of this year has made the timing of a rate hike more uncertain and diminishes the chance of a rate hike this summer. As you can see in Figure 1 below, which shows the Citigroup US Economic Surprise Index, US economic data has been surprising on the downside, suggesting that the US economy is losing momentum. At the same time, inflation has fallen to a six-year low as oil prices have plunged. The question now is will the sluggish economy delay the start of the Fed rate-hiking cycle? Figure 1: Citigroup US Economic Surprise Index
Source: Bloomberg and FOREX.com.
In our view, the Fed is unlikely to hike interest rates in June. So when might they hike rates? To answer this, we have looked at the Fed’s own projections for rate hikes taken from its latest meeting (at the time of writing) in March. As you can see below, seven FOMC members expect interest rates to average around 62 basis points by the end of this year. This would equate to more than two rate hikes by year-end. The plurality of Fed members expect rates to equal 1.62% in 2016, with three members expecting rates to rise above 3% by the end of next year.
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Figure 2: Appropriate pace of policy firming: Midpoint of target range or target level for the federal funds rate Number of participants with projected midpoint of target range or target level.
Note: Each number in the table represents the number of Federal Reserve participants that project the federal funds rate will be at the corresponding level at the end of the specified calendar year or over the longer run. Source: Federal Reserve.
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Interestingly, the market is pricing in a slower pace of rate hikes than the Federal Reserve itself. As you can see in the chart below, the market is pricing in only 36 basis points of tightening by year-end (see Figure 3), less than half of what Fed members are predicting. By September, the market is pricing in a mere 22 basis points of hikes (see Figure 4). Figure 3:
Source: Bloomberg and FOREX.com.
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Figure 4:
Source: Bloomberg and FOREX.com.
So who is right? Unless we see a pickup in growth the Federal Reserve is unlikely to hike interest rates, even if it wants to. The weak economic data since the start of the year and signs that momentum slowed further at the start of Q2 suggest that the market may be correct in underpricing the prospect of rate hikes. However, interest rates are already at low levels so a hike could be in the pipeline even though the economy is not firing on all cylinders, especially if the Fed is planning on a slow pace of hikes once it gets started. The contrasting expectations between the Fed and the market make it harder to determine when a rate-hiking cycle will start, what it will look like, and the potential impact on global financial markets.
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2, What Will the Rate Cycle Look Like? Because we believe that the details of a potential US rate hike remain highly uncertain, we decided to come up with three potential scenarios for the next rate cycle in the US. 1, The market is right: In this scenario, the first rate hike doesn’t come until December 2015 and the pace of tightening is gradual thereafter. The Fed decides to take a cautious approach after a spate of weak economic data in Q2 and Q3 but finally pulls the plug on low rates after inflation starts to pick up in Q4 2015. This is a departure from the Fed’s usual ratehiking cycle and makes the long-term future of US interest rate hikes highly uncertain. A slow pace of hikes from the Fed may limit dollar upside in the second half of the year. Treasury yields may also stall, but global stocks could rally and emerging market (EM) currencies, particularly the South African rand, Brazilian real and Turkish lira, may also stage a recovery rally in the second half of the year. 2, The Fed is right: In this scenario, the market was underestimating rate hikes. The Fed hikes rates in September and at each meeting until the end of the year. It suggests that the rate-hiking cycle will continue well into 2016, and rates could rise above 1.5% next year. This could hurt global stock markets as investors decide to take profits. Investors could also pull back from foreign positions, especially in the EM space, as fears grow about weaker capital flows to the EM world now that rising US rates spook the market. While it is logical to assume the dollar would rise in such a situation, the last time the Fed hiked rates more aggressively than the market expected back in 1994/5, the dollar actually fell, as you can see in Figure 5 below. This unexpected reaction could have been due to fears that the rapid pace of interest rate hikes would hurt economic growth moving forward. Figure 5:
Source: Bloomberg and FOREX.com, please note that these prices do not reflect prices offered by FOREX.com.
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3, The Fed delays hiking rates until 2016: This may occur if the US economy continues to lose momentum through to the middle of the year. The Fed may choose to delay rate hikes until the economy reaches optimal “escape velocity” growth. If it waits until the US economy is stronger, then the Fed may be able to embark on a normal rate-hiking cycle, with consecutive hikes, rather than an on/off approach as discussed in scenario one. Consecutive hikes may be preferable to the Fed as it makes for clearer communication with financial markets, and could also protect the Fed’s credibility. Depending on which path the Fed decides to take, this could have big implications for financial markets in the coming months, which we will look at below.
3, The Market Implications After a long period of interest rates remaining at zero, the prospect of a rate hike is likely to cause market disruption. As we mention above, the scale of the market reaction could depend on the pace of rate hikes in the coming months and years. With such an uncertain backdrop, we have decided to take a look at the technical pictures for the US dollar, USD/JPY (U.S. Dollar/Japanese Yen) and the S&P 500 in both the long and short term.
The US Dollar: The US dollar has been in a prolonged uptrend since the start of Q3 2014, surging by around 25% over that period. As of writing, the rally in the trade-weighted dollar index has lost some of its steam, but the world’s reserve currency is still holding near its 12-year high at the key 100.00 level. The buck continues to put in higher lows, consistently finding support at its 50day MA near 97.00, but there are some signs of concern for bulls. For one, the dollar index put in its first significant lower low since the uptrend began in mid-April, suggesting that the bullish momentum may be waning. The simultaneous reversals in both the MACD and RSI indicators bolster the bearish case: the MACD has been trending lower beneath its signal line for over a month, and the RSI is now firmly in neutral territory at 50. As it currently stands, we’re inclined to give the established bullish trend the benefit of the doubt, but if the dollar index breaks below its 50-day MA and horizontal support in the 96.00 area, it may precede a deeper drop. In that case, bears may want to look toward the 100-day MA around 94.00 or even the 200-day MA down near 90.00, especially if it looks like the Fed is unlikely to raise interest rates at all in 2015.
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Figure 6:
Source: Stockcharts.com & FOREX.com.
USD/JPY: As a general rule of thumb, USD/JPY (U.S. Dollar/Japanese Yen) tends to see the cleanest reaction to US monetary policy, so any changes in the Fed’s rate intentions could have a big impact on that pair. Lately, rates have been merely consolidating in slow trade around the 120.00 level, and the pair has not made a new closing high since back in early December. The MACD and RSI are both moving sideways in neutral territory, underscoring the balanced, two-way trade in USD/JPY. The recent stabilization within the broad 116.00-121.80 range appears to reflect the expectation that the Fed will raise rates in the September-December timeframe. Therefore, if the odds suggest an earlier or more aggressive hiking schedule, USD/JPY could break out of its recent consolidation and make a run for the Fibonacci extensions of the sideways range at 123.55 (127.2%) or 125.70 (161.8%). On the other hand, expectations of late or very gradual rate rises could push USD/ JPY back down to the bottom of its recent range at 116.00; below that a key support level to watch is the 200-day MA around 114.00.
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Figure 7:
Source: FOREX.com.
S&P 500: The S&P 500 has been in a strong upward trend for several years now. As can be seen on the weekly chart below, the index has been rising inside a bullish channel since October 2010. While it is anyone’s guess how much longer it will continue to climb higher inside this channel, there are a few warnings signs that suggest a pullback may be in the cards for the near term. The RSI for example has created several instances of bearish divergence by putting in lower highs while the underlying index put in higher highs, suggesting that the bullish momentum is weakening. What’s more, a bearish trend line is potentially forming around the 2100/20 area which has provided stiff resistance since the index hit a record high of 2120 in February. That being said, none of the key support levels, such as 2040, have broken down as of yet, and even in the short term the outlook is still moderately bullish. But if 2040 is taken out eventually, a move towards the support trend of the bullish channel and prior lows around 1980 may get underway. Meanwhile, if the index pushes above the aforementioned bearish trend line, then the next key levels to watch are around 2138 and 2147. These levels correspond with the 161.8% Fibonacci extension levels of the 2007-9 bear trend and the downswing from September to October 2014, respectively. Beyond these levels is the upper trend of the bullish channel, the exact location of which depends on the speed of the potential rally. Overall, the technical outlook for the S&P is bullish and may remain that way until/unless proven wrong (e.g., a break of the 2040 support level or significantly, the lower trend of the channel). SPECIAL REPORT
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Figure 8:
Source: FOREX.com.
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Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions. Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan. Please read Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp).
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