At 4am tomorrow on the east coast of Australia, 2pm New York time, the US Federal Reserve’s Open Market Committee will announce its decision on whether it will increase interest rates for the first time since May 2006, and in doing so begin the long anticipated Fed tightening cycle.
Even though, at most, rates will only rise from the current zero percent to still incredibly low 0.25% the decision, to hike or wait another month, is the most anticipated and important event in global markets for years.
Tonight’s decision has the potential to affect the entire financial world, including Australia, the Aussie dollar, commodity prices and the outlook for interest rates.
This is because the low interest rate regime which saw the Fed cut rates from 5.25% in August 2007 to zero percent by December 2008 was a result of acute economic weakness in the US and global economies as a result of the sub-prime crisis which morphed into the GFC. The post 2009 world, which has included not only zero interest rates in the US but also three rounds of QE from the Fed, has contributed to speculative excesses which make global financial markets vulnerable as investors have become used to threaten the very recovery higher stock prices were supposed to support.
Yesterday Richard Koo, chief economist at Nomura Research Institute, made the case strongly that all this unconventional monetary policy has done was drive capital into higher yileding and riskier asset classes with little money hitting the real economy.
In reality, however, neither private credit nor the money supply have demonstrated meaningful growth in spite of massive infusions of liquidity by the central banks of Japan, the US, and the UK — as should have been expected given the absence of borrowers.
The lack of growth in private credit in these three countries means most of the funds supplied by the Fed, the BOE, and the BOJ never reached the real economy, which in turn explains why inflation rates remain so low.
If that money didn’t make it into the real economy, then it’s sitting in financial assets. Thus, a change in Fed policy, a tightening, has a number of impacts both here in Australia and around the globe.
Forex markets are complex. That’s because unlike other markets where you can buy a share, a bond, or a barrel of oil, when you undertake a forex transaction you are simultaneously buying one currency and selling another one.
Take the Aussie dollar for example. It is usually quoted as AUDUSD = 0.7182. That means one Aussie dollar will buy 71.82 us cents. So when you trade you are not only buying that one Aussie dollar but you are selling US cents. Similarly an AUDNZD rate of 1.1313 means that one Aussie dollar will buy you $1.1312 New Zealand, or 113.12 Kiwi cents.
That’s important because the end to quantitative easing last year and expectations about the Fed tightening drove the US dollar higher. Because that’s the other side of the Aussie dollar pairing, it put the Aussie under pressure, driving it down against the greenback.
Indeed for all the talk of commodities driving the Aussie this relationship suggests the US dollar, and its overall moves, play a big role.
So, if the Fed raise rates tonight, or indeed at the October or December meetings, it is likely to support the US dollar and put the Aussie under further pressure.
Australia has a concentration in iron ore, coal, gold and LNG when it comes to commodity exports. And, while these are key inputs into Australia’s national income it’s the overall direction of commodity prices that investors and traders, starved of time and focussing on bigger markets, pay attention to.
So it’s important to understand that the USD is also a key driver of commodity prices as most of them are denominated in US dollars. So, like a foreign exchange pairing, as the US dollar rises or falls, then the price of a commodity in Australian dollars, Brazilian Reals, Norwegian Krone, or Chinese RMB changes as well.
From an Aussie dollar perspective that is a double feedback loop, either positive or negative.
And the Aussie dollar’s rise and fall is a crucial factor in determining the course of monetary policy – interest rates – in Australia.
Should the Fed tighten and the US dollar strength and the Aussie fall this will give a boost to the Australian economy. However if the Fed passes and the Aussie dollar continues its recent rally this will act like a defacto tightening of monetary conditions within the domestic economy.
Short-term interest rates are set at the prevailing needs of the economy by the central bank. In Australia the RBA cash rate is currently sitting at 2% and the RBA seems comfortable watch the economy evolve for the moment. Rates in the US are at zero and likely to rise through time.
But central banks don’t set long bond rates, they only set the cash rate (usually). But rates in the US, and to a certain extent Australia are rising on longer term (3-year and 10-year) bonds because markets believe the cash rate in the US is headed higher.
That’s important on three fronts.
First, higher bond rates influence corporate borrowing costs and so feed into borrowing intentions. The intent to borrow money is a driver of “animal spirits” throughout the economy.
Second, higher 10 year government bond rates increase the so-called “risk free rate” by which other investments like stocks and physical assets are discounted at. You’ll have heard talk about “hurdle rates” within companies which determine whether investment projects go ahead. Higher interest rates, generally speaking, can mean a lift in hurdle rates too. The RBA has complained about what it believes are hurdle rates that are set too high in corporate Australia in an era of low interest rates.
Higher bond rates now mean a higher discount factor in the future which means the net present value of the earnings stream associated with those investments is lower than it was before the bond rate rose.
Think about that for a second in a world where PE’s are at the highest levels except for periods just before we’ve seen market crashes.
It might also be worth revisiting Henry Blodget’s discussion from August about the chances of a stock market disaster scenario looming over the horizon.
The third impact is higher bond rates in one nation relative to another tend to support the nation with the higher or increasing rate. Thus, with the relative spread of interest rates between Australian and US rates compressing you get a sense of another area of weight on the Aussie dollar.
It’s not hard to see why so many banks turned uber bearish on the Aussie dollar recently. The negatives are really lining up.
This bond market outlook is important because as my Business Insider US colleague Sam Ro pointed out last night the “last surprise Fed rate hike was followed by the ‘bond market massacre’ of 1994.” Believe me when I tell you those were not fun days to be managing a billion dollar interest rate portfolio.
Market players generally agree that stock prices are vulnerable. That does not mean a crash is guaranteed. Indeed, the acute weakness of August in the US, Australia and elsewhere on the back of concerns over China, among other things, was the “the selloff we had to have” to many observers.
But investors also know that the big QE uptrend in US stocks has been broken in the past six weeks. As I highlighted earlier this week in one of my daily 20 Seconds reports my colleague Myles Udland from BI US put together an interesting, I think telling, little piece about the governor of floor trade on the NYSE Rich Barry in which he highlights that Barry said the game has changed for traders. That is, this is no longer a “buy the dip” market.
When looking at the big picture, we think it may be time to sell rallies in the market. Until we can see the market extend to fresh new highs, we think the game has changed and we may find ourselves in this ‘consolidation-mode’ for a while. Just a gut-feeling…
Certainly the technical outlook fits with this, and traders’ moods have clearly been rattled by the recent volatility, in both the US and Australia. If the Fed moves this week, traders have been psychologically prepped to start selling.
So it’s a big night tonight.
Currently as we countdown to the decision at 4am tomorrow morning Fed Fund futures markets are pricing less than 30% chance of the Fed moving rates. That’s well short of the 70% Larry Summers says the market normally has priced in when the Fed tightens.
That implies the risks tonight are for higher stocks, a higher Aussie dollar, bouncing commodity prices and falling bond rates. But, whatever the Fed does it will reverberate around global markets and the economy. And if they don’t move tonight, they will have to eventually, and the market thinks that will happen by the end of the year.
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