y Colin Cieszynski, CFA, CMT, CFTe, Chief Market Strategist, CMC Markets
For many of life’s major events like getting married, buying a home or car, going on a trip, having a baby, and others, there’s never a perfect time, but there is an optimal time.
Likewise with central banks, there’s never a perfect time to start raising interest rates, and waiting too long for the perfect moment can have negative consequences. For the FOMC, enough stars appear to be aligning to make late 2015 an optimal time to start raising interest rates for the first time in a decade.
Since wrapping up its QE3 stimulus program last October, traders have been speculating on when the Fed may start raising interest rates. A soft start to the year for the US economy and a drop in inflation following the oil price crash delayed liftoff from the spring, but with US headwinds fading, the time for liftoff appears to be approaching.
Last month, at the Fed’s Jackson Hole conference, FOMC Vice Chair Fischer reminded the street and public that “monetary policy influences real activity with a substantial lag”. Generally speaking the rule of thumb for many central banks is that it takes about 12-18 months for an interest rate change to work through the economy.
It’s also important for traders to remember that interest rates near zero are well below inflation which on core measures are still running well above 1.0%. An increase this year would be continuing the removal of stimulus that started with the beginning of tapering in December 2013, and not tightening. Keeping stimulus going for too long increases the risks of asset bubbles forming which can have negative longer-term effects for markets and the economy.
Traders should also recall that interest rate cuts and emergency measures like QE and zero or negative interest rates are emergency measures that reflect economic weakness. Interest rate hikes are a sign of strength.
There are many reasons to suggest the last three meetings of this year are a good time for the Fed to start raising interest rates.
Economic FactorsDeflation risks are receding
The big crash in oil prices started in June of 2014, accelerated through late 2014 and initially bottomed out in January and then March of 2015. Now that a year has passed since the crash started, the impact of the big drop in oil prices is going to be lapped over the next several months and deflationary pressures are likely to ease in the coming months.
Meanwhile many inflation measures show higher inflation than headline numbers would suggest
CPI ex food and energy 1.8%
GDP price index 2.1%
Real average weekly earnings 2.2%
Average hourly earnings 2.2%
PCE core 1.2%
As this happens, inflation should start to work its way back up toward the 2.0% goal of many major central banks including the Fed. Vice Chair noted in his recent speech “we should not wait until inflation is back to 2 percent to begin tightening”
The risk of inaction on inflation is growing
I’ve been comparing trading this summer with the summer of 1998 which also saw a mid-cycle stock correction, emerging markets crisis, and fall in energy prices.
At that time, the Fed cut interest rates, which sparked a big stock market rally over the next year, but also sparked a big jump in inflation. From 1.7% in September 1998 when the fed cut interest rates, inflation rose to 2.3% a year later and 3.8% by April of 2000 just over 18 months later. There is a growing risk that if the Fed waits much longer it could get behind the curve on inflation which could force it to raise rates more aggressively later in a bid to catch up.
The risk doing nothing could send a negative signal is growing
Zero interest rates and QE were brought in during a major financial crisis as emergency measures to shore up confidence and keep the financial system running.
With the housing market recovering, unemployment down near 5.1% and GDP growing in Q2 at a 3.3% clip, we’re getting to a point where instead of applauding a delay in liftoff, the street could start to see it as a sign of weakness.
A year ago, talk of QE4 stopped a stock market selloff cold in its tracks, recent talk of QE4 was greeted with a lot more skepticism.
Anectodal reports out of the Jackson Hole conference indicated that a number of other central banks, particularly in emerging markets indicated to the Fed that they are ready for a rate hike and that the Fed should get it over with because there is now so much focus on the timing of liftoff it’s becoming a distraction in the markets. A delay could drag this problem on and on.
Inaction could have longer term effects as well. The panic Fed cuts of 1998 helped to spark a massive bubble in technology stocks through 1999 that was a great party at the time but ended in tears and one of the biggest stock market crashes of the last 100 years. In hindsight, the 1998 Fed panic attack was the tipping point that started the decade long decline in former Fed Chair Greenspan’s stature from “The Maestro” to “Mr. Bubble”.
Market Expectations and Timing Factors
Looking at how stock markets and USD have performed around previous initial interest rate hikes indicates that now looks like a particularly good time of year for an initial rate hike.
The table below looks at the performance of the Dow in the months before and after an initial Fed rate hike dating back to 1970, 1980 and 1,990.
Results show that the stock market has declined on average in the month before and the month after an initial rate increase. The data also shows that following an initial bout of weakness, stock markets have then staged strong advances as focus returns to economic growth and a positive environment for corporate earnings
Stock returns over the last year have been softer than previous cycles but this can be attributed to the fact that the street has been anticipating liftoff through and particularly since the end of QE tapering. A rate hike has clearly already been priced into stocks and the sooner it happens, the sooner stocks can move past it and refocus on economic and earnings growth.
The table below shows that US Dollar action around initial interest rate increases is mixed. Perhaps most importantly, it indicates that a rate hike does not necessarily mean that the USD may continue to rise from here.
Returns over the last year show that most of the gains were between 12 and 6 months ago and since February, USD has been flat to lower. In other words, a rate hike has been fully priced in since March, so the Fed should just get on with it already.
Stock Markets and Seasonality
Historically the weakest time of the year for stock markets runs between mid-August and mid-October. This year, there has been a summer selloff with the potential for a retest of the lows within the next month if similar patterns from 1998 and 2011 continue to play out.
Since the stock market has historically been weak in the month around an initial rate increase and markets are down already, now would be a good time to get liftoff over with, which could then set the stage for confidence to kick back in right about the time we enter the more seasonally favourable period for stocks between mid-October and the end of the year.
Monetary, Political and Psychological FactorsThe Fed needs to reload
The Fed has been pushing pedal to the metal for many years now and needs to normalize interest rates to give itself some breathing room. Otherwise, it could face the next downturn or crisis with no firepower.
Other central banks have benefitted from previous moves to set aside firepower for a rainy day. For example, the two interest rate hikes Canada made back in 2010 came in handy in 2015 when the oil price crash hit the energy sector. More recently, the four interest rate hikes made by the RBNZ in 2014 have given it lots of room to cut interest rates aggressively when the wheels came off in 2015.
Back in 1998 when an emerging market crisis hit, the fed funds rate was at 5.25% and inflation was at 1.7% giving the Fed lots of scope to cut real interest rates. Today, with the fed funds rate at 0.25% and inflation measures running 1-2% the Fed doesn’t have much scope to push new stimulus into the system since real interest rates are already well into negative territory.
The Fed needs to reassert itself and remind the street who is in charge here
Over the last twenty years, the Fed has become increasingly market friendly with the Greenspan put becoming the Bernanke put becoming the Yellen put. There also have been signs of an active Plunge Protection Team, particularly in October 2014 when talk of QE4 halted a market plunge and sparked a big turnaround.
The market support of QE programs seems to have left many thinking that the markets can tell the Fed what to do. The old Fear of the Fed has gone by the wayside it seems.
In recent months, the Fed has started to reassert itself, particularly in indicating it could act at any meeting not just ones with press conferences.
Last month at Jackson Hole, Fed Vice Chair Fischer reminded the street “The Fed;s statutory objectives are defined in terms of economic goals for the economy of the United States.” And “By maintaining a stable and strong macroeocnomic environment at home, we will be best serving the global economy.
In other words, the Fed is focused on the US first. The Fed considers itself the world’s premier central bank and expects others to follow its lead. The tail does not wag the dog.
Recent calls from the IMF, World Bank and other third parties on the Fed to hold off on raising interest rates could end up having the opposite effect. The Fed may now need to raise rates to show it doesn’t take its marching orders from anyone else.
Besides, if one to ask around they might find several countries who would say they would have been better off doing the opposite of whatever the IMF told them to do, starting with Greece.
2016 Presidential Election Campaign
Jockeying for position among Presidential candidates for both parties is already underway with primaries kicking off in early 2016. The Fed may want to get an initial interest rate increase out of the way to avoid it becoming an election issue. Don’t forget Republican candidate Rand Paul's father wrote a book called “End The Fed”.
Possible Voices of Dissent?
The permanent voting members of the FOMC including the governors and the New York Fed president rarely dissent. Instead, it is usually some of the voting rotating regional Fed presidents that carry the banner for dissenting factions.
Chicago Fed President Evans is one of the most consistently dovish members of the FOMC. He has called repeatedly to wait for 2016 or longer, so he would likely dissent to a rate increase this year to the dovish side.
Richmond Fed President Lacker recently gave a speech called “The Case Against Further Delay”. He would be likely to dissent to any decision on the hawkish side to a decision to delay liftoff.
San Francisco Fed President Williams and Atlanta Fed President Lockhart have both suggested in recent speeches they could see the Fed raising interest rates this year. Both also, however, have kept their options open as to when, following the party line of watching the data.
It’s unlikely either would dissent to the dovish side and stand in the way of an increase, but they probably would not fight a September decision to delay either. They are likely to stick with the party line with a small chance of dissent on a decision to hold.
What meeting could the rate hike come?September 17 (40% chance of a first rate increase)
gets the decision over with so the markets can focus on other things heading into earnings season next month
with member projections and a press conference, the Fed can manage expectations of future policy trends
aligns the decision with the middle of the weakest time of the year for stocks
There’s still a lot of uncertainty in the markets about China’s economy, we’re only a few weeks out from a really volatile period and markets could benefit from a short delay to let everything settle out.
October 28 (70% chance of a first rate increase if Fed does not raise in Sept)
Gives the Fed a chance to make sure turmoil in China is contained and easing.
Enables the Fed to get a better idea on how Q3 went in the US and early signs of fall economic trends.
Enables the Fed to signal liftoff coming in September.
Shows the street that it can raise interest rates at any meeting and helps it to regain some flexibility.
Fed decision could overshadow the start of earnings season
Not quite as well aligned with stock market seasonality but not a bad time either.
December 16 (90% chance of a first rate increase if Fed does not raise in Sept or Oct)
Gives Fed lots of time to monitor the economy and world trends and still sneaks an increase in by the end of the year. This is what the Fed did with its first QE tapering in December 2013.
Member projections and press conference give the Fed lots of avenues to discuss its reasoning and outlook.
Drags out speculation on when liftoff may happen which could become a distraction.
There is a risk that the window of opportunity for liftoff could close
A December liftoff could impact trading through the holiday season and could undermine the potential for a seasonal bounce in November/December (aka the Santa Claus Rally).
As a point of comparison, recent press reports indicate Fed funds trading suggests traders have priced in a 28% chance of a hike in September, 40% chance for October and 60% for December
Split between the three meetings, I think the chances of liftoff are 40% September, 50% October and 10% December.
And then what?
So, if the Fed does raise interest rates, then what? Over the last several months, several Fed speakers have indicated that the interest rate process would be slow and gradual. This points to an earlier start because the longer the Fed waits, the more aggressive they may need to be once they get started.
An initial hike this year is likely to be accompanied by a dovish statement suggesting no more increases for a while. (one and done for now). This is a big contrast from 2004-2006 when the Fed raised rates from 1.0% to 5.25% over the space of two years.
One interest rate increase is unlikely to crash the US economy and probably won’t be noticed by consumers at all. After all, who is paying below 1.0% interest rates, banks, hedge funds and governments? For consumers in major developed countries, mortgages run around 3%, credit lines around 6% and credit cards 10% and up.
Following the initial increase, traders may then start to speculate on how the Fed may start running down the reserves it built up over its 3 QE programs. Sometime next year, the Fed could stop reinvesting interest received, or stop rolling over assets as they mature with outright sales likely still a long way away.
Chart In Focus: Gold, the Canary in the Coal Mine
Gold, as the world’s top hard currency, often trends in the opposite direction to USD, the world’s leading paper currency. How gold trades over the next few days could reflect speculation on which way the Fed could be heading.
Through the first half of 2015, gold steadily trended lower as speculation the Fed was moving toward normalizing interest rates put a tailwind behind USD.
In August, however, gold bounced back strongly as market turmoil and volatility in China spilled over into other markets, particularly stocks and commodities. Speculation that a China stock market crash could destabilize its broader economy and impact the rest of the world sparked speculation the Fed could be forced to delay liftoff to 2016.
Over the last few weeks, however, Chinese markets have stabilized and strong US economic data including GDP and employment reports have apparently put the Fed back on track. The RSI indicator at bottom indicates momentum has started to accelerate to the downside. Should $1,100 fail, the July low near $1,070 could be tested or possibly even $1,000 on a rate increase.
Conclusion: The Optimal Path to Normalization
After several years of extreme dovishness, the Fed appears ready to embark on a course toward normalizing interest rates. This means aligning the interest rate with inflation likely around the 2.0% target for both used by many central banks around the world.
It seems most likely that the Fed will not raise interest rates this week, but will most likely use the member projections, statement and press conference to signal that liftoff is likely before the end of the year. We could see one or more hawkish dissenters in the voting.
Unless something really goes off the rails over the next six weeks, this would put the Fed on course to start raising interest rates at the end of October. We could see one dovish dissenter on a rate increase.
The Fed likely would then go on hold for the rest of the year with the next increase possible in January or March of 2016.
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