After a long buildup that stirred waves of turbulence in global markets, the Federal Reserve is finally expected to end its seven-year crisis stance with an interest rate increase on Wednesday. About 97% of economists surveyed by the Wall Street Journal expect the increase to happen.
America's central bank slashed rates to near zero in December 2008 to stimulate the economy. The Fed has kept rates at those historic lows ever since and It is almost certain that the fed will start raising the interest level during the next meeting by the federal open markets comity at 7PM GMT tomorrow. How worried should businesses, investors and policy makers around the world be about the end of near 0 interest rates and the start of the first monitory tightening cycle since 2004-2008?
Janet Yellen the chair of the Federal Reserve has said repeatedly that the impending squeeze of rates will be slower than previous cycles. She predicted that it will be at a lower level. We know that central bankers cannot always be trusted when they make such statements because one of their most important attributes is to mislead investors. Many reasons make us believe that their commitment to lower interest rates for longer is actually true. The FEDs objective is to hike inflation and ensure that it stays above 2%. To achieve this, Yellen will have to keep interest rates very low. After inflation starts rising she has to follow Paul Volcker’s steps in keeping interest rates in the 80s high. Any hike in interest rate, if it happens will signal the end of the bond bull market that dates all the way back to 1981.
During the 80s, Volcker’s task was to reduce inflation and keep it from rising again to high levels. Today, Yellen’s task is to increase inflation and prevent it from falling again to low levels. Under these conditions the direct economic effects of the FEDs decision should be minimal. It will be implausible how businesses, consumers, home owners and markets in general will have to overcome their financial issues for a quarter point change in short term interest rates. If long term rates move roughly and reach 1-1.5% by the end of 2016, which is historically very low in absolute terms and relative to inflation.
Officials from the IMF and other institutions pointed out that the impact of the FEDs first move will be on the financial markets and economies. Many countries such as the Asian nation and the Latin Americans will be deeply affected by the reversal of the capital inflows from which they benefited when US interest rates were at its current levels. The imminent US rate hike was predicted so nobody should be caught off guard if the FEDs move see the light next month. February 1994 and June 2004 are the only comparable periods to the present one. Even then the stock markets reaction to the FEDs tightening was weak, while bond market volatility proved to be short lived.
What about currencies? The dollar is almost universally expected to increase in value when the US Interest rates begin to rise. Especially because the EU and Japan will keep their monetary conditions as they are for years to come. The fear of a stronger dollar is the real reason behind concern causing panic in many emerging economies and within the IMF. A significant strengthening of the dollar will cause serious problems for emerging economies where most of the businesses and states took on huge dollar-denominated debts where currency devaluation tends to run out of control.
Three reasons make the specialists within the economy believe that the raise of the US interest rates concerns are almost incorrect.
First reason, the divergence of monetary policies between the states and other major economies is expected. Therefore, the interest rate differential like the US rate itself should already be priced into currency values.
Second, monetary policy is not the only poll of the exchange rates. Trade deficits and surpluses also matter. The stock market and property valuations, corporate profits, economic growth and inflation are part of the same important polls.
Finally, the widely assumed relation between monetary policy and currency values does not stand up to empirical examination. Currencies move in the same direction as monetary policy but in some cases the opposite does happen.
Comparing the past with the present events is not always the right thing to do but in many cases tends to shed a light on what will follow. A rise of the dollar is not automatic or inevitable if the Fed raises interest rates this month. The globally disrupted effects of US monetary tightening / rapidly rising dollar, capital outflows from emerging markets, financial distress for international dollar borrowers and currency devaluation in Asia and Latin America may vary less or more in next year’s economic circle.
Yellen has repeatedly said that the lift off from zero will initiate a series of increases whose pace will depend on how the economy reacts -- slower if there is weakness, and faster if it picks up strength. For that reason, most eyes will be on what the Fed and Yellen say in statements and in forecasts about their expectations for economic growth and the expected level of the fed funds rate at the end of 2016 and 2017.
Make sure you monitor your open positions when trading in volatile markets and take advantage of stop-loss and limit orders. In volatile markets, the price of a certain currency can move very quickly. We encourage you to be vigilant and never trade with funds you cannot afford to lose.
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