The September FOMC playbook

This meeting is the most important macro event in years and will be scrutinised by all parts of the market.

Yellen Fed Reserve
Source: Bloomberg

On Friday at 04:00 AEST, the Fed will disclose whether they are going to target a higher fed funds rate. Janet Yellen, the chairman, will give a press conference 30 minutes later, where she will field questions on any changes to monetary policy or economic projections.

Financial markets are pricing an increase in the funds rate at a 28% probability, rising to a 56% chance by the December meeting. Economists are a touch more bullish with just over 50% expecting the Federal Reserve to lift the fed funds rate by a range of between 25 to 50 basis points. Here the Fed will use various financial tools to control short-term interest rates (such as commercial paper, treasury bills, repos and one-week libor) and guide the cost of money higher within this range – the weighted average of these rates is the so-called ‘effective rate’: the price of borrowing short-term funds.

Why raise rates?

Between September 2008 and January 2015 the Fed expanded its balance sheet 400% by generating huge levels of liquidity through quantitative easing. Of course, this led to banks holding ever-increasing levels of capital with the US central bank, but this surplus of reserves has seen both long and short interest rates in the US, fall to very low levels.

There are now so many distortions in markets that have been created by artificially low interest rates and excess liquidity that these have to be addressed at some point. From the angle of sheer financial stability that point is now.

We know equities have benefited from Fed easing in recent years, with the bottom line predominately driven by corporates using the zero interest rate environment to borrow funds in the bond market at record low levels and ultimately buying back stock or increasing dividends. Either way, there has been a strong return on equity driven from CEOs.

The misalignment and mispricing of assets is a true concern for the Fed.

With growth above 3% and the economy in full employment (at 5.1%) we can also make a case that inflation could follow even though core PCE is trending lower and five-year inflation expectations are still too low.

Will they raise?

I absolutely hope they do. However, I feel that with only a 28% chance priced into interest rate markets, Janet Yellen will hold fire, as there is no doubt that a 25 basis-point move in the funds rate will cause the USD to spike and risk assets (such as equities) to be sold. That is at least until Janet Yellen can use the press conference to smooth out the volatility and let everyone know that the process of raising will be very gradual.

The 30-minute period between 04:00 and 04:30 AEST could be very volatile and whippy indeed!

If the Fed did raise rates, it would send a clear message that they are in control of markets, not a slave to them. Of course, an aggressive stance could backfire and recent commentary has suggested they are not looking to upset anyone. With the IMF, World Bank and ECB all highlighting downside risks to global growth, a policy mistake could send risk assets into a more protracted sell-off.

I suspect they will guide the market, saying they are more focused on lifting rates in December and watching financial conditions very closely. I interpret financial conditions as implied volatility in assets, credit spreads (both high yield and investment-grade), interbank and longer duration interest rates.

Recent moves in markets

In some ways, it’s worth looking at the moves since the June meeting, which is effectively when we last received the banks economic projections. Since the June meeting the S&P 500 has lost 6.5%, the 10-year treasury 11 basis points, investment grade credit has widened 25 basis points and the trade-weighted USD has gained 5%.

The US volatility index (the VIX) has traded between 10.9% and 53.29%. There is clearly much uncertainty being expressed and this lack is thematic of a market feeling exposed to a future tightening of financial conditions.

Watch economic projections

Don’t be surprised if we see growth projections for 2016 being lowered to a range of 2.3% to 2.4%, with core PCE being lowered to a range of 1.4% to 1.8%. The central projection for where the various Fed members see the future funds rate (the so-called ‘dots’ plot projection) is likely to be lowered from the current projection of 1.62% in 2016 and 2.87% in 2017. I would not be surprised to see the 2016 projection closer to 1.4%.

The key assets to watch on the day

The two- and five-year US treasury will tell you the real picture around whether the market is disappointed by what they hear. A sharp move lower in yield and higher in price will suggest a strong dovish tone and this will hit the USD.

It’s well documented that the USD is pivotal for emerging market assets, so expect a strong rally in currencies like the ZAR or MXN if the Fed leaves rates unchanged. With over $9 trillion in USD-denominated liabilities outside of the US, a spike in the USD will be felt as the cost of servicing this debt increases. Watch the USD.

A hike in the September meeting could see the USD rally 2% on the day, but a lot will hinge on Janet Yellen’s ability to control markets.

How to trade the day

What we really want is certainty. For me, the market gets more clarity from a ‘one, done and gradual’ mindset rather a ‘hold off for now’ stance, which I feel is the higher risk. A September hike then gives us certainty, although I suspect the equity market won’t see it as a positive.

It really all boils down to what Janet Yellen says at 04:30 AEST, but recall in her time at the helm that she has always looked to calm markets when major policy announcements have come. I quite like the idea of selling rallies in AUD/USD into $0.7170 and the May downtrend, as well as EUR/USD into the August high of $1.1650 to $1.1700 on disappointment.

The S&P 500 is consolidating and I am therefore neutral for now, but I do like the idea of shorting the index on a break through trend support at 1934 for 1900, and even the August lows.

There is no denying this meeting is the most important macro event in years. It will be scrutinised by all parts of the market.

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