Expectations are high that the US Federal Reserve will lift interest rates at the conclusion of its FOMC meeting this week, lifting investor anxiety. Many analysts now believe the rate rise is ‘baked in”, and are complacent about the potential for a market reaction. This dynamic, combined with thinly traded holiday markets, makes a significant market move more likely.

This makes the “shape” of the announcement important. It’s widely expected that a rate rise will come with a dovish statement and a clear attempt to soothe investor nerves. Some may be overlooking the fact the Fed will also have to lay out its case for the rise itself, suggesting growth is accelerating and inflation is trending towards the 2% target level. Making this argument could limit the impact of any offsetting calming statements about future interest rate rises.

A significant market reaction after the announcement of the Fed decision on Thursday morning (6 am AEDT) is therefore a real possibility.

The first suspect will be the USD, but not necessarily in the way economic text books predict. The problem with an economics 101 approach to markets is that it takes no account of market positioning – that is, the actions of market participants, and the positions they take, can influence the market reaction to that event.

USD traders have been building higher interest rates into the market scenario for some time. The US Dollar Index (the USD measured against a basket of other currencies) rose 27% between June 2014 and June 2015 as the Fed stepped up its tightening talk. It then pulled back by 10%, but recently resumed its rise to near the twelve year highs.

While higher US rates will likely see the USD higher over the longer term, this currency positioning leading into the announcement could bring the opposite. A “sell the fact” reaction could see the USD rally strongly against EUR and JPY, as well as the AUD. An AUD/USD at 0.76 or 0.78 US in the weeks following the decision is not out of the question.

What does this mean for share markets?

 

Some investors are surprised to discover that share markets generally RISE through the first period of an interest rate tightening cycle:

 

 

20151215 sp500(Source: Bloomberg)

 

 

This chart shows the S&P500 Index performance in the lead up to, and after, the beginning of the last five tightening cycles in US interest rates. While individual years vary significantly, the average performance over the following 6, 12 and 24 months is positive. This is often explained by the fact that interest rates are rising due to an improving economy – one where company profits are also on the rise.

 

This brings investors to another piece of conventional wisdom. “Emerging” markets (loathe that term) will fall as investment funds flow back to the US, attracted by a higher return environment sparked by higher interest rates. This idea is theoretically appealing. However, given the widely flagged nature of the rise, the long lead time and the fact that valuation arguments are much more supportive of emerging market shares could once again see surprising market moves in the wake od a rate hike.

What does all this mean for Australian shares?  A strengthening AUD, and rising markets in China, Brazil and India?  A falling USD pushing commodity prices higher? These look like the ingredients for a share market rally. The pressure on commodity stocks in particular, and commodity exposed markets and currencies generally, is weighing on the local market. The US Fed’s rate rise could be the trigger that releases this pressure and sees the ASX 200 move back towards the middle of the 4900 – 6000 range.