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The Federal Reserve has been in a state of monetary easing since the beginning of 2008, having dropped rates from a little over 6% to 0.25% today (source). One of the biggest questions on investor’s minds is: when will rates begin to normalise again (i.e. rise)?
This is an important question because low rates means that businesses can borrow cheaply and consumers can get loans and products on credit cheaper. Both of these factors ultimately lead to more money flowing around the economy and thus an increase in economic growth (at least in theory).
Furthermore quantitative easing and low interest rates brings down the yield on bonds, making them less of a desirable investment and therefore causing the stock market to rise, as investors look for yield and bet on cheap credit allowing companies to expand more. It can therefore be deduced that an increase in the Fed Rate is highly likely to cause the stock market to wobble a little bit and experience some volatility.
A recent futures trade in the volatility index (an index that gains in value as the stock market becomes more volatile) registered almost $100mil in one second, one of the biggest trades in history (source). This could suggest there are investors out there who think increased volatility might occur with an interest rate rise (bloomberg article) and are investing now in anticipation.
Factors influencing rise
The main mandates for the Fed are inflation and unemployment. Inflation currently sits at -0.1% Y-Y (source) and the unemployment rate is at 5.4% (source), down from a peak of 10% during the financial crisis. Inflation is the main factor here, as it sits quite far below the 2% target for the Fed.
The unemployment rate is strong and has exceeded the benchmark of 6.5% (source) for the Fed to suggest a change in rates.
Inflation however is mainly struggling due to commodity prices, such as oil prices falling. Furthermore it is expected that as the labour market becomes more saturated we will see an increase in wages, which could trigger a sharp increase in inflation.
The Fed has indicated to the markets that a rate rise could occur this year, by removing the word ‘patient’ from their monthly report (source) and also a recent talk from Janet Yellen who suggested that some stocks could be overpriced (source), which indicates that she might be actively talking the market down to reduce the effect of an interest rate rise. The Fed had also previously indicated a rate hike in June (source), however the market expects rates to slowly rise up to around 70bps by 2016, starting in September, as inflation data is too weak to justify a rise soon.
The Fed have to be careful that they don’t upset the balance of the world markets. Currently Europe is in a state of heavy monetary easing, including quantitative easing of €1 trillion (source) and UK rates are to remain at 0.5% for the meanwhile (source). Therefore there is could be concern that a raising of the Fed Fund Rate could see a flight of capital from Europe to America, as investors look for the higher fixed income yield.
This happened in the build up to the Great depression in the thirties, due to the Gold Standard, and the result could be the Dollar appreciating a great deal (harming USA exports) and a shock to world stock markets. However the Fed is likely to increase rates gradually, hopefully reducing the cause of a shock increase. Janet Yellen is also utilising the new practice of Fed Guidance (source) to ensure the markets have the required information to digest a rate rise.
Ultimately a rise is due, because rates are at unprecedented levels. Markets suggest a rise in September, but in my opinion it will all be down to the inflation level, which doesn’t look too comforting at the moment. However if the labour market remains as strong as it is right now wages should begin to rise substantially, furthermore the effects of low oil prices take roughly a year to filter through. With both of these factors we should see the required pressure on inflation that would cause a trigger in the Fed Rate.