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A look ahead at the Federal Reserve

All eyes are on the Fed ahead of the interest rate decision and any action or inaction will impact all asset classes.

Federal Reserve
Source: Bloomberg

As we head towards the Fed decision on 16 December it is time to look at the current economic situation and the potential market impact of any action that the Fed may (or may not) take.

Policymakers, including Fed chair Janet Yellen, have been talking about increasing US interest rates for some time now, and considering strong growth in the US economy and the steady fall in unemployment, the central bank would have justification to do so.

Ms Yellen is concerned that if interest rates stay at record lows for too long it could lead to another credit bubble, and if rates aren’t hiked now it could lead to several hurried hikes next year. Most traders are anticipating an interest rate hike and the Fed will not have to worry about a major reaction from the markets should they increase rates.

US GDP
US Unemployment

There is no doubt that rock-bottom interest rates and three rounds of QE have helped the US economy to get back on track, however the strong US dollar dogged the corporate reporting season and the slowdown in emerging economies has yet to be fully played out.

US factory activity contracted in November and the ISM manufacturing index dropped to a six-year low as weak overseas demand was compounded by a strong greenback.

Ms Yellen may be hesitant to hike rates in a year when many central banks are loosening their policy.

Headline inflation is being hammered by commodity prices and there is no sign of that changing anytime soon.

Core inflation is creeping higher but it is just shy of the Fed’s 2% target, and in the past the inflation rate has been closer to 3% when the hiking process began. 

US ISM
US CPI

The US dollar hit its highest level since 2002 this year and it is currently up over 10% year-to-date, and should rates start to rise the greenback will stay in demand.

Gold has fallen out of favour with traders as the prospect of a rate hike has taken the shine off it; should the Fed raise rates gold will continue to be punished as investors flock to interest bearing products. Base metals and energy markets will also suffer from a tightening of the Fed’s policy as they are priced in US dollars.

In the short-term, stocks will suffer from a rate hike. It might provide a buy-the-dip opportunity as historically stock markets have rallied post interest rate rises in the medium-term, as it suggests the US economy is strong enough to withstand higher borrowing costs.

Janet Yellen has talked about a rate hike for so long if she doesn’t pull the trigger it will give the impression the US economy still isn’t strong enough, which could lead a rise in the US dollar as the ‘flight to safety’ trade takes hold, and sending stocks lower on this sign of economic weakness. 

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