The FOMC bringeth frankincense, myrrh and rate hikes

The beginning of the first Fed rate hiking cycle since 2004 began this morning (AEDT) as most had expected.

Janet Yellen
Source: Bloomberg

The only uncertainty was what indications the statement and the press conference would give for the future path of rate rises. Judging by the dramatic moves in the dollar index in the wake of the decision, the FX markets are still trying to make their minds up about whether we have seen the cyclical peak in the US dollar or whether it has further to go.

What is clear is that equity markets are taking the rate hike as a positive. TheS&P 500 has now rallied 1.5% and all the futures markets for the Asian session are looking to see markets open 1-2% higher across the board. If Asian markets do look to be holding their positive opening calls at the open, we could see the ASX moving over 5100 and possibly achieving 2% gains in back-to-back sessions.

The fact that the Fed were able to hike rates indicates that the US economy has finally developed enough upward momentum to withstand higher interest rates. The question for many investors now is whether this momentum in equity markets is likely to develop into a full-blown “Santa Rally” into the end of the year. With little further market moving releases expected over the coming weeks and a still dovish trajectory for future Fed policy, there does seem to be a good chance of this happening. It is worth noting that historically 16 December has been the seasonal beginning of a “Santa Rally”, so its timing with the Fed meeting does seem particularly auspicious to those with equity portfolio holdings.

Things in the energy sector are looking less positive as WTI oil dropped 4.5% in the wake of the blowout in EIA weekly oil inventories. US oil inventories grew by 4.8 million barrels against expectations for them to decline and refinery capacity utilisation rates also declined. Despite this the HYG high yield ETF still ended the day in positive territory, gaining 0.7% and bringing some calm to the high yield credit concerns. This has largely cancelled out the rally of the past few days driven by expectations for Congress to remove the ban on US oil exports. Gold and silver on the other hand, have been rallying as the future path of rate hikes by the Fed looks set to be “accommodative”.


  • The Fed dot plots left their expected trajectory for the Fed funds rate at the end of 2016 unchanged at 1.4%. This would entail four rate hikes in 2016, but currently the market has only priced in expectations for 2.5 rate hikes in 2016. At the moment, the market does not appear too concerned, indicating a confidence that the Fed rates trajectory should become more in line with its own over the year.
  • It is important to note that historically the second and third rate hike in the cycle has been more negative for equity markets. Based on the current WIRP bond market probability, the most likely next date for a rate hike is the Fed’s June 2016 meeting (65.8%). The WIRP is pricing in an 81.7% probability that rates will remain unchanged at the Fed’s January meeting, with a marginally higher likelihood given to a rate cut than a rate hike for January!
  • Janet Yellen stated that the strong domestic demand was cancelling out the negative contribution from net exports due to the strong US dollar. It may seem counter intuitive, but a “dovish hike” at the December meeting could quite likely be the best way to weaken the US dollar and in turn help the embattled US export sector. Uncertainty around the first Fed rate rise has now ended and markets do not believe another rate rise will happen until June – this is likely a perfect formula to see the USD weaken in the near term.
  • One big unknown was seemingly put to rest in the Fed statement, which said that the runoff of the Fed’s balance sheet is not likely to begin until “normalization of the federal funds rate is well under way”. Fears of a rapid liquidation of the Fed’s balance sheet look unlikely to occur, and even a minor decline may not be seen until after 2016.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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