the us rate decision (september 2015)

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Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530

The US Rate Decision: What to Expect and3 Possible Surprises

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Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530 Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530

Disclaimer: The views and opinions expressed in this article are those of the author alone and do not necessarily reflect those of Pepperstone Group Ltd. Analysis in this article is based on limited information and is not provided as investment advice or for education purposes. Readers should conduct their own research or seek a professional advisor before trading.

On Thursday the 17th September the FOMC will conclude its meeting in which it will decide on raising US interest rates for the first time in a decade.

In this paper we examine the challenges the FOMC faces in deciding to raise interest rates in the United States, the process by which they expect to normalise policy and the potential market impacts that could occur. This event is likely to be one of the largest to impact financial markets in the last decade, and the ramifications in currency, stock and bond markets is likely to be dramatic regardless of the exact timing of the first rate hike. Traders should be aware that the potential for market volatility is extremely high, and price movements could be well outside of usual daily trading ranges. We hope that this paper can help prepare traders for some of the possible outcomes, and have a better understanding of the situation overall. We break down the article in to five parts:

1. An Introduction to the Event – What is this about and when can I expect it?2. The Current State of the US Economy – Is the economy ready for higher rates?3. Expected Market Implications – What markets are expected to be most impacted?4. Possible Surprise Reactions – How the market might get caught off guard5. Addendum – The Nuts and Bolts of Normalisation – A crash course in economics

An Introduction to the EventThere is an unshakable sense that almost every market and every trader has been focused on a single critical event this year – the expected first rate increase in the US for almost 10 years. It is unlikely that a lone 25 basis point increase has ever been so heavily debated, delayed, rescheduled, anticipated, feared and loathed quite so much as this one. The debate is lively, in part, because the expectations of the rate rise have unwittingly helped to push inflation to lows that could shake the resolve of even the most determined policy hawk; meanwhile, US employment has continued to improve with the regularity of Swiss clockwork and shrugged off the effects of the commodity price collapse and rapid US dollar appreciation.

For a central bank faced with a dual mandate to tend to both of these economic indicators - inflation and employment - it certainly feels that the Federal Reserve is damned-if-they-do and damned-if-they-don’t.

The focal point of markets has fallen on the September FOMC meeting - for which the policy decision and press conference will be held on the 17th of September (from 21:00 server time) along with the committee’s updated inflation and growth forecasts for the next two years. Before the most recent energy price collapse in August, markets had become taken with the idea of a first rate increase at the September meeting; however, as oil prices breached new lows of less than $40 USD per barrel and China acted to weaken its currency in a surprise move, market expectations have been trimmed back drastically to around 23% probability for a move this month.





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There is a substantial disagreement between what markets are currently pricing and what analysts and the FOMC members themselves have indicated for the path of normalisation. Markets have not priced the first hike until the December meeting, while economists still expect overall that the Fed could make a move this month - the divergence between the two makes the potential for a market surprise quite real, regardless of whether the Fed decides to tighten at this meeting or not.

The FOMC themselves do not get to update their projections of expected interest rates on a frequent basis, and there is much debate over whether the projections from the June FOMC meeting will still be accurate when the committee meets in September. The projections from that meeting are below, and indicate that a large portion of the FOMC expected more than one rate increase this year – we will not find out until the September release if that remains the case.

The Current State of the US EconomyThe largest hurdle the Fed faces in having a green light to raise interest rates is that CPI inflation is bordering on deflation - as it has held at around the 0% for several months this year. The Fed has a target inflation rate of 2%, and although core CPI and other smoothed measures are holding up better by filtering out energy price declines, it is not an easy sell to raise interest rates while inflation is near its GFC lows and market implied inflation expectations are in a steady decline.

Indications from Yellen and other FOMC members are that they believe this deflationary energy shock will be transient; when the one-off falls in oil prices have filtered through the year-on-year figures, things will begin to look healthier for inflation measures. Oil prices first reached the low $40’s per barrel level in early 2015, so barring another major leg down in prices this could see the price declines pass through year-on-year inflation in the first half of 2016 – allowing for a recovery towards target from mid-2016 onwards.

When looking at inflation figures, the Fed may try to look ahead by around 12-18 months – which is the time many believe it takes for monetary policy to begin to work on the economy. Because of this time consideration, the FOMC may be willing to ignore or ‘look through’ the falling prices that are seen now, as long as they are ‘reasonably confident’ that inflation will begin to return to target over the next 1-2 years.





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Another consideration that the FOMC have made is around the pace of tightening, which may be affected by the start date for lift-off. Previously, Janet Yellen has indicated that a gradual rise in rates is preferred, implying an earlier first hike and a gentle pace of increases so as not to shock markets too much. The reason for caution here is that if the Fed instead waits until inflation has returned to target, or overshoots it to the upside, then they may be forced to raise rates rapidly to prevent inflation getting out of hand – having the potential to cause a large amount of financial stress and another credit crunch. FOMC member Eric Rosengren suggested in a speech this month that FOMC expects tightening to occur at around half the pace of the previous cycle in 2004.

The second part of the Federal Reserve’s dual mandate is to promote maximum employment; on this measure the Fed is on track to succeed, with the unemployment rate almost back to what it considers the natural rate of unemployment. As of the last reading this month, unemployment is back to 5.1% and the CBO’s long term natural rate of unemployment is estimated to be approximately 5% - using these measures the employment recovery appears to be nearly complete.

What may give the FOMC confidence to raise interest rates is that, as the slack in the labour market is taken up and the economy nears full capacity, wage pressures will begin to grow in the labour market to help support inflation’s return to target. Wage growth has been fairly anaemic since the GFC, which may be partially explained by

wages being ‘sticky’ downwards – meaning that employers are reluctant or unable to cut wages by as much as may be warranted under the economic circumstances – causing an additional slack in wage pressures that needs to be taken up; if this is correct, wage pressures and inflation have been further delayed by the need for the difference between nominal wages and the true value of labour to be absorbed. If the economy is starting to reach full employment, then wage growth may finally overcome this barrier and materialise to end the era of low inflation.

Other measures of economic health seem to indicate that the US economy is reasonably healthy. GDP growth and cyclical measures such as industrial production are growing despite scepticism about the upcoming tightening. Real GDP growth is now comfortably in the 2-3 percent range which, while not booming, is a fairly healthy rate of growth.

If FOMC members are correct in their belief that inflation will return to trend, then most other measures of the real economy would give them a green light to go ahead. What is still very much up in the air is how markets will handle the tightening cycle. Stock markets have benefited from an era of very accommodative policy that has allowed price-earnings multiples to climb in recent years; whether the removal of this accommodation will take the wind out of the stock market’s sails is something that is in the front of many investors’ minds.





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Expected Market ImplicationsThe expected effects of a US tightening cycle are already evident in various pockets of the global economy, including declining commodity prices, financial stress in emerging markets, US dollar strength and increasing market volatility. Expectations are that, should the Federal Reserve continue to tighten in the current environment, stress will continue to build in these other parts of the world even as the US economy powers forward. While so many markets are affected by the Federal Reserve’s policies, the central bank may not be able to ignore its own domestic situation in order to make things easier for foreign economies.

In a situation where the Fed embarks on a tightening cycle out of step with a sluggish global economy, the divergence in economic prospects could continue to heavily affect economies tied to commodities and those who have borrowed in US Dollars.

In a situation where the Fed embarks on a tightening cycle out of step with a sluggish global economy, the divergence in economic prospects could continue to heavily affect economies tied to commodities and those who have borrowed in US Dollars. China, who runs a loose peg to the US dollar, may be forced to devalue further and break its strong ties to the dollar in order to save its own economy. A weakened Yuan could depress Chinese commodity demand from external sources even further. One consequence of this currency weakening, or liberalisation, could also be for China to offload its foreign exchange reserves to slow the Yuan’s descent to a manageable rate – reducing its reserve buffer against a currency crisis in the future.

With these effects in mind, it is easy to envisage of a feedback loop that sees emerging markets in particular facing terrible economic pain. Commodity price declines could further depress emerging market economies and exacerbate

currency weakness against the US dollar; if those economies have large exposure to US Dollar denominated debt, then funding issues could be the next domino. In the past when the value of foreign debt service increases with the exchange rate, emerging markets have typically run in to debt or currency crises. The situation could be a cornucopia of economic malaise, before even considering that some of these economies could also have burgeoning housing bubbles – such as commodity exporters Canada and Australia.

Possible Surprise ReactionsThe expectations from the previous section are very much ‘known unknowns’, and the market should have at least attempted to price in the direct and indirect effects of the first rate rise. Further continuation of the economic dislocations of 2014 and 2015 as a result of US outperformance are likely to depend on the pace of subsequent rate increases and the ultimate peak of the tightening cycle. If the market has underestimated how rapidly the Fed will tighten, then more of the same could be in store for battered energy and commodity producers.

We have already had a preview of the effects for an unexpectedly swift US policy normalisation over the last 12 months, and the media is full of negative speculation about the prospects for non-US economies as a result. With most being aware of the potential dangers of this tightening cycle, it may be more constructive to think about what could happen if the hype and anticipation that has been generated over the last 12 months has caused people to overestimate the effects of a US tightening. Here are some contrarian scenarios to balance out the debate:

Surprise 1: The market reacts in a risk off manner, but the US Dollar is not the chosen safe haven

People might still be scratching their heads as to why the US dollar sold off from August 19th to the 25th, in tandem with stock markets worldwide. It seemed almost as if the US was no longer the safe haven of choice as it has been for much of the time since the onset of the GFC. One theory to explain this unexpected move is that of the transition between how the US dollar – and indeed the Euro and Yen – are seen as funding currencies.





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Through the wake of the GFC, when the US held rates at zero and performed multiple rounds of quantitative easing, the US Dollar became a ‘funding currency’ for risk positions or carry trades; funding costs were low and expectations were that the US dollar would continue to weaken against stronger economies currencies. As US prospects have improved over the last two years, sentiment has shifted positively towards the country - even more so now that the country is expected to enter a tightening phase – and use of the US Dollar as a funding currency is considered to be a much riskier proposition.

At the same time, across the Pacific, Japan was moving the Yen deeper in to its place as a funding currency; ‘Abenomics’ saw the country embark on a very large scale program of Quantitative Easing - which would then be expanded in October 2014 – leading to a persistent currency depreciation. Across the Atlantic, Europe was putting together the makings of an asset purchase program and another series of LTRO programs to stimulate the economic bloc. As one of the easing measures, the ECB also moved interest rates in to negative territory for the first time – all but cementing the Euro as a funding currency for risk positions due to a low cost of funding. The Swiss Franc finds itself in a similar position now that interest rates are also firmly negative at -0.75%, though with the dramatic moves in the Franc this year the currency has been treated with more caution than the other two.

A funding currency will often lose value during good times as risk positions build up using the currency as the source of funding – traders are short the funding currency and long risk assets; this is commonly known as a carry trade in FX, and it has the unfortunate consequence of unwinding rapidly when market sentiment turns sour – similar to how margin debt is rapidly reduced when the stock market crashes.

Interestingly, despite the US economy being generally considered the economy with stronger economic prospects, unwinding risk positions can mean that currencies such as the Euro, Yen and Swiss Franc act as the stronger safe havens. Given this explanation, it is no surprise that the August stock market crash was accompanied by strength in these currencies and a substantial ‘short squeeze’ of the positions built up in the US dollar. The Dollar found itself part of a broader group of risk currencies that sold off heavily, in a reaction that caused much surprise. A tightening cycle should theoretically move the US Dollar further away from a position as a funding currency. Most recently the US dollar fell in lock-step with stock markets:

The surprise reaction in this scenario is that the rate hike is taken by the market in a risk-off manner, causing a stock market selloff in the US as well as abroad. If the new paradigm of the Euro and Yen as funding currencies holds firm, then a stock market rout could actually see a surprise appreciation in these two currencies and a mixed or negative reaction for the US Dollar. With US Dollar positioning at extreme levels this could be quite explosive.

To some extent this reaction depends on how dependent market valuations are on monetary policy, or how risk sentiment reacts to monetary policy. In some prior cycles, the stock market been driven by strong economic growth – the horse (economy) pulling the cart (stock market). Sometimes it is sentiment that pulls the market higher, or even the market gains themselves that encourage further speculation. One example of this would be the 1990’s tech boom, where much of the gain was price-earnings multiple expansion rather than purely earnings growth; in this situation it is the cart (stock market) pulling the horse (economy) whether it chooses to follow or not. Was quantitative easing and ZIRP the market’s good news story, or was the strong rebound in the economy the main driver of the markets?

Surprise 2: The big question – is it already priced in?

So often in markets when everyone expects one thing to happen, the opposite occurs. Markets are constantly surprised when the obvious is suddenly so obviously wrong. Examples of this litter the recent past, can you remember what you were thinking would happen next in the lead-up to the major announcements below?





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Quantitative Easing: The general consensus from analysts and economists was that long term interest rates were going to fall when QE started due to the Federal Reserve buying such large quantities of bonds. When the programs started, yields jumped higher in a counterintuitive reaction (red), but began mysteriously dropping each time the Federal Reserve stopped buying bonds and exited the market (blue):

Tapering: in a similar vein, when QE ended there were fears that the lack of demand for bonds would see yields rise and cause trouble in loan markets and for US debt service. Surprisingly, yields fell quite consistently from the moment the Fed tapered, and continued falling even after it completed the tapering process (yellow, above).

QE 2: When QE 2 was to be announced, there were expectations that it would cause another period of US dollar weakness and it was often regarded as ‘printing money’. In another counterintuitive move, the dollar sold off against currencies like the Euro right up to the day of the announcement, and then without obvious reason reversed course and strengthened for months afterwards:

European QE: As recently as this year, there was near consensus that it was a matter of when, not if, the Euro would plummet past parity with the US Dollar as the market built up expectations for a QE program from the ECB. Negative sentiment towards the Euro reached fever pitch in March this year, when QE finally began and the ECB began creating Euros to buy up assets. After falling for the first couple of days of the program, the Euro has been remarkably resilient since QE started, and it may take an expansion of QE or a sustained US tightening to move it lower.

In most of these cases, the market had already priced in the effects of the monetary policy change before it began. Once the policy changes were announced this signalled the end of the journey for a lot of traders.





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The problem could well be that, in most of these cases, the market had already priced in the effects of the monetary policy change before it began. Once the policy changes were announced this signalled the end of the journey for a lot of traders, and their positions being closed out caused a counterintuitive market reaction. The question of how much of the tightening cycle is priced in will be at the forefront of many trader’s minds when it comes to the FOMC announcement.

Surprise 3: Currencies and Stocks React Explosively

US Stocks: US stocks are one asset class that has moved in a single direction for several years. Even August’s rapid sell-off ranked quite low in terms of historical market declines, and markets have since recovered around half of the drop. By a number of measures, US stocks are in the upper end of market valuations globally – with many believing the easy monetary policy of the last 6 years has been responsible for building up a speculative fever and appetite for risky assets. Stock market bears, having been

burned by the rally have gone quiet in recent months; if they get a sense that the market is finally turning they could come back in a big way.

The Australian Dollar: The AUD reached a post-crisis low value of 69 cents against the US Dollar last week – a massive fall from grace after breaching the $1.10 level back in 2011. Even if our first surprise were to occur and the US dollar was sold off during a market crash – this does not mean that the AUD can only go up. There is a chance that both currencies sell off, and the AUD continues to fall relative to the US dollar. However, if US dollar positioning does unwind and that ends up supporting commodities – the AUD could be one surprise beneficiary of a relief rally.

The Euro and Yen: As funding currencies outlined earlier, these both do have a lot of potential to benefit from a risk off movement. The Euro in particular is one where the markets position is overall very short, though not quite as short as when QE was announced by the ECB. Both stand to move violently on any risk position unwinding, however both also have inherent risks as there is suggestion that both the ECB and the BoJ could expand their current QE programs in the near future to counter the deflationary shock of falling oil prices. A risk off rally in these currencies could be short lived if it spurs their central banks in to further easing action. With markets and analysts still split down the middle over which way the Fed will go at this meeting, one side will turn have to be wrong at the end of the day. This divergence in opinions means that while the market may have tried to price in the rate change, it may still get caught out on the timing of the move – so a move this week, or even a delay to the first move to a later date by the Fed could both surprise the market, it will just be a different section of the market that is surprised. Traders may want to make sure they are prepared for the announcement by checking positions and ensuring there is enough margin available in their accounts for any open positions or new trades.

If you are interested in the mechanics of how normalisation will work, please read on to the Addendum.





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Addendum - The Nuts and Bolts of NormalisationWhen the Fed does decide to raise rates, this tightening cycle might look a little difference to the last one. Since the onset of Quantitative Easing, the multi-trillion dollar build-up of excess reserves has had some unintended consequences that mean new mechanisms will need to help the Fed set an interest rate range; the Fed will also need to decide when to stop reinvesting maturing bonds and allow its balance sheet to deflate.

In the Federal Reserve’s 2014 document Policy Normalization Principles and Plans they outlined the procedure that will form the normalisation process:

1. When economic conditions and the economic outlook warrant a less accommodative monetary policy, the Committee will raise its target range for the federal funds rate

2. During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances.

3. During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate.

Explaining these steps in detail requires going in to a little more technical detail about the challenges the Federal Reserve faces in raising rates – those brought on by the excess reserve balances in the banking system.

Bank reserves are a bank’s deposits held in their accounts with the central bank; reserves are generally required for the purpose of holding as security against any loan the bank makes, and the amount required is typically controlled by the reserve requirement ratio. ‘Excess’ reserves are those held above the amount required by a bank’s reserve requirement. Since 2008, the large excess balances are a direct side

effect of banks intermediating the sale of bonds to the Federal Reserve during the QE programs it ran from 2008 to 2014.

Holding excess reserves was not a conscious choice by banks, but an unavoidable effect of having the Federal Reserve pay for the securities purchased under QE with Reserve Balances, which it does by expanding its balance sheet. Effectively, the Fed creates reserves from thin air to purchase an asset (in this case a Treasury bond) from a bank and in doing so creates a liability on its balance sheet (the reserves it pays the bank with). Because the reserves that banks receive in this process are not attached to any loan, there is no reserve requirement involved and they become ‘excess’ reserves.

The banking system can do little to get rid of the reserve balances in aggregate, and only banks themselves can hold reserves – meaning these excess reserves serve little real purpose for the broader economy. If left to their own devices, banks would seek to get rid of these reserves by lending them at progressively lower rates to other banks until the overnight rate reached zero, as any return is better than none. To counteract this massive downwards pressure on the overnight federal funds rate, legislation was changed to begin paying interest on excess reserves (IoER). IoER is intended to form the new lower bound of interest rates, as banks should have no incentive to lend out their reserves at any rate lower than the risk free interest rate paid on them – alleviating the downwards pressure and giving the Fed more control over raising rates while excess reserve balances exist.

Unfortunately, because not all participants in money markets can hold reserve balances, the payment of IoER is not quite enough to set a firm floor on the overnight rate. Banks theoretically can earn an arbitrage profit by borrowing in money markets at any lower rate than IoER, and then earn the IoER rate from holding reserves with the Fed, which should make the floor hold by bidding up short term borrowing rates to the same level as IoER. In reality, this arbitrage is not costless due to capital requirements and other costs incurred by banks, so there can be a divergence between money market rates and the IoER rate set by the Fed to place a floor on overnight rates.





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Chris Hewitt is a market commentator and part of the currency analyst team at the Melbourne headquarters of forex broker Pepperstone.

Chris has a Bachelors degree in Economics specialising in monetary policy, and has been trading and following a range of markets for 5 years.

With these excess balances conspiring to make it difficult for the Fed to raise short term interest rates to a desired level, it set about looking for a way to involve a broader range of counterparties in its setting of the overnight rate – including a range of money market funds and government sponsored entities that are not depository institutions, but for whom dealing in money markets is a necessary part of business. Enter the Overnight Reverse Repurchase Agreement (ON RRP), which can be used with the new broader range of ‘eligible participants’.

RRP’s are a tool that the Fed has been trialling as a supplementary measure to IoER in setting the Fed Funds rate. A reverse repurchase agreement works in the following manner:

1. The Federal Reserve will offer to sell a security from its balance sheet to eligible participants, with the promise to buy it back the following day at a set price.

2. When the Federal Reserve repurchases the same security the following day, it does so at a slightly different price to the sale price.

3. The difference in price represents a yield to the participant that can be used to set a floor under short term interest rates, because there should be no incentive to lend below this risk free interest rate.

4. The Federal Reserve offers US Treasury securities as its RRP collateral, which it accumulated during QE.

The ON RRP would form the floor on an interest rate range, as expanded counterparties would not have an incentive to lend below this rate. The IoER rate would form the upper ceiling of interest rates – together they would allow the Fed a stronger degree of control, however FOMC members intend the ON RRP to be used only as-needed and to hopefully be phased out as soon as possible once rates are at a more normal level.

The other part of the normalisation process – reducing the size of the Federal Reserve’s balance sheet - will not follow at least until the first rate increase is out of the way. As the Fed explained in its normalisation principles:

1. The Committee expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate; the timing will depend on how economic and financial conditions and the economic outlook evolve.

2. The Committee currently does not anticipate selling agency mortgage-backed securities as part of the normalization process, although limited sales might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public in advance.

It is expected that at first, when the Fed believes the time is right, it will end its reinvestment policy as its first step. This policy has up until now seen the Fed reinvest maturing security proceeds back in to the market in order to keep its balance sheet steady. By ending reinvestment, the size of the security portfolio held by the Federal Reserve would begin to decrease through a natural decay over time, without putting any unnecessary strain on market rates by directly selling its securities.

Indirectly, the process of ending re-investment is considered a form of monetary tightening – as it increases the supply of securities on the market, meaning longer term interest rates may move higher than they would under a continued policy of reinvestment. Because this policy change could result in an opposite effect to QE (higher long term interest rates) the Fed is expected to wait until it is certain the market can handle it, which could potentially be a year or more from when it first raises rates. The Federal Reserve estimates it could take around 7 years to normalise policy.

Disclaimer: The views and opinions expressed in this article are those of the author alone and do not necessarily reflect those of Pepperstone Group Ltd. Analysis in this article is based on limited information and is not provided as investment advice or for education purposes. Readers should conduct their own research or seek a professional advisor before trading.





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the us rate decision (september 2015)

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