This week, the Fed will have its FOMC meeting on Tuesday and Wednesday, culminating with an announcement as to whether or not there will be a change in interest rates. This announcement will be at 2:00 pm New York time (18:00 GMT), followed by a news conference by Fed Chair, Janet Yellen, where she will talk about the state of the economy. So who gives a hoot? Everybody, perhaps, besides one lone Tibetan monk living in a monastery atop Wangbur Mountain without internet service.
A basic principle in investing is the significance of interest rates. They determine the pace of economic activity, by controlling the costs of doing business. As currency traders, we know that, everything being equal, the countries with the highest “real” interest rates will have the strongest currencies. There are certainly glaring exceptions to this rule of thumb, such as the Japanese Yen, and of course it does not mean you should buy the Russian Ruble just because their interest rate is ten percent. Which is why I say, everything being equal. That’s a discussion for another day, or if you can’t wait, drop me an e-mail now. We can therefore understand why a .25 increase or decrease in interest rates, particularly if it is a surprise, can turn the market on its head.
Last December, the Federal Reserve Bank increased short-term interest rates and hinted that there would be another three to four rate hikes in 2016. But there haven’t been any. Why not?
First, there was the fear that the weakness in the Asian markets would spread worldwide. Then came Brexit. After the Brexit vote, the markets were in real turmoil. An increase in interest rates would have further destabilized an already fragile market. Now we are hearing the line that the Fed doesn’t get involved in politics; a change right now in Fed policy might be viewed as the Fed taking sides in the contentious presidential election in early November.
A number of Fed officials, including Janet Yellen, recently indicated they could support a rate hike at this meeting, yet the Federal Funds market is now telling us that there is only a 12% chance of a rate hike this week, with a higher probability of a rate hike in December.
So why the change in sentiment?
Weak economic numbers were released this month, including August job growth, industrial production, and business inventories. The producer price index showed no change and retail sales were weak too. There were no signs of inflation.
Furthermore, the markets were looking forward to Fed Governor Brainard’s speech last Monday. This speech could have foretold a rate hike, but was unexpectedly very dovish. Governor Brainard warned that the Fed shouldn’t “move too quickly” on rate hikes and advised “prudence in the removal of policy accommodation.”
On the one hand, a premature rate increase can cause damage in this struggling, low growth economy. On the other hand, if we don’t get ahead of inflation, it will be uncontrollable when it comes.
Aside from the Fed, the Bank of Japan also meets on Tuesday and Wednesday to review its stimulus efforts. The BoJ policy makers are split over whether or not to step up its easing strategy. Other major central banks are also grappling with weak growth. The European Central Bank left its policies unchanged this month. The Bank of England signaled more rate cuts later in the year.
What are we to do? Top off your account, buckle your seat belt, and get ready for action. Between now and Wednesday, the market might present many opportunities for the astute investor. Watch out for the knee-jerk reaction after the announcement. Be ready to pounce if the situation presents itself.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.