Better late than never, it looks like Santa Claus may have finally arrived after all. Having dropped off sharply through the first half of December, as has been common just ahead of the Fed starting to raise interest rates, stocks and crude oil bounced back sharply yesterday. Rebound momentum has continued through overnight trading in Asia Pacific markets and on into this morning’s European and US trading.
Positive flash manufacturing PMI for France and Germany have combined with stronger than expected UK job growth to keep the party going enabling markets to build on yesterday’s relief rally. Crude oil successfully retesting its 2008 low near $35.00 is also helping lift spirits this week.
Markets now appear to be ready for the main event of the month, Wednesday’s FOMC meeting where the US central bank is expected to raise interest rates for the first time since before the 2007-2009 Great Financial Crisis. Economic data of late has indicated the US economy is ready for emergency measures to start being lifted. Several FOMC members have indicated a preference for starting to raise rates this year and move gradually afterward rather than wait too long and risk destabilizing the economy having to move aggressively to catch up.
So, the street is expecting a 0.25% increase to the 0.25% to 0.50% band. Fed Chair Yellen and New York Fed President Dudley have indicated rate liftoff should be seen as a sign of confidence in the economy, so an increase as expected should help to support stocks and corporate earnings expectations through the end of the year and on into 2016.
Anything less than a 0.25% increase would come as a big surprise to many which could send stocks and USD plunging again as we saw when the Fed held off in September. This is because with a rate hike having been strongly signalled by FOMC members a decision to back away from expectations would raise a lot of questions about the health of the US economy. Rather than the celebrations of the past, a dovish Fed would likely be greeted by a chorus of what’s wrong. Recall the action two weeks ago when the ECB didn’t go as dovish as the street had thought. We could see the same kind of violent action if the Fed does not go as hawkish as thought
Indications from the Fed in the statement, member projections or press conference on its interest rate normalization plans for 2016 could also have a significant impact on trading in some markets. The big gains of USD over the last year which drove Gold and other currencies down seem to have priced in expectations of a program of steady increases as in previous cycles.
The “dot plot” of member expectations from the September Fed meeting below suggests that assuming a 0.25% hike in December 2015, expectations for the number of 0.25% hikes in 2016 are as follows: 2-4 increases (0.50% to 1.00%) 8 members, more than 4 hikes (more than 1 hike per quarter) 8 members.
Source: federalreserve.gov
Fed Chair Yellen has suggested the neutral interest rate is likely to be lower this quarter, while FOMC Governor Brainard implied that the neutral rate this cycle could be closer to 1.25% rather than the 2.25% of past cycles.
This suggests that the dot plots are likely to come down and that the Fed may not be as aggressive going forward as some people think. The USD Dollar Index has already shown signs of peaking. I suspect with the rate hike we will see a lot of dovish talk from the Fed that it will be some time before the next increase (street generally expecting March 2016). A less aggressively hawkish Fed outlook could send USD lower and send gold, other currencies and stocks higher, while tough talk from the Fed could have the opposite effect.
Whatever the decision, we will likely see a flurry of activity in the first few minutes after the announcement as traders rush to get onside that could spark quick moves in both directions before traders settle on a trend.
GBP and the FTSE may also be active through the day tomorrow. There has been a lot of speculation that the Bank of England could be the next central bank to raise interest rates and Governor Carney has been waiting for the Fed to clear the launchpad for him. UK employment figures may also spark another round of speculation on whether the Bank of England could move sooner or later. Comments from Bank of England Governor Carney suggesting conditions are not yet in place for a UK rate hike have been weighing on GBP this morning.
Personally I think the Fed will raise rates three times in 2016, March, June and December, skipping September to stay out of the election campaign, taking rates up into the 1.00-1.25% zone. I think the Bank of England will raise twice once in the spring and once in the fall to get back to 1.00%.
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