Interest rate developments
After the Fed held interest rates in a unanimous decision in May’s monetary policy review; markets are now anticipating a rise at June 12/13’s Federal Open Market Committee (FOMC) meeting and are pricing further hikes throughout 2018. According to the CME, traders are assigning a 51% chance of a 4th interest rate increase by the end of the year.
While Fed officials are currently indicating three hikes throughout the year, we’ll have to wait until the June FOMC meeting for an update of their forecasts.
David Lojko, co-founder of Earn2Trade
LLC states, “with interest rates expected to rise next month and more hikes to follow; we’ll see uncertainty developing in the markets, greater price movements and increased volatility”.
The CME Fedwatch tool indicates a 95% chance of a June increase – the probability has been 100% as recently as last week – and an 81.4% percent likelihood of another move in September.1
The Fed’s latest monetary policy statement expressed confidence in its economic outlook, stating “business activity had been expanding at a moderate rate and employment growth had averaged strongly in recent months”.2
As per the official data, the country’s unemployment rate is 4.1% which is at a 17-year low and inflation is rising to the Fed’s 2% goal.
The US economy is expected to grow between 2.5 – 2.75% in 2018.What does this mean for the markets?
A rate rise – especially if it’s a cycle to increase rates on a gradual basis as the Fed is indicating – directly strengthens the dollar. As the dollar strengthens, this leads to downward pressure on assets such as oil and industrial metals due to the higher cost of financing commodities in dollar terms.Commodities
Commodities prices tend to decrease when interest rates rise as investors move to assets that produce a higher yield. Gold recently hit a 4 ½ month low and one would expect crude oil to decline, however, recent geopolitical events in the Middle East have boosted oil prices. The International Energy Agency
stated the impact on global crude oil supplies pending US sanctions on Iran ‘is unknown at this point’.Stocks
Typically, rising interest rates are considered bad news for stock markets, although they tend to affect different sectors in different ways. Low rates have been a major contributor to the equity markets rally over the past 10 years, and as bond yields are increasing it makes stocks a less attractive investment. Other factors such as lending becoming more expensive and the associated high costs it entails further reduce earnings.
On the other hand, financial stocks tend to perform strongly as banks may see their margins benefit from an interest rate rise.Currency
As expected with the prospect of increased interest rates, the USD enjoyed a rally in recent weeks while most central banks elsewhere are pushing back policy tightening. The USD rally in European trading reached a year high that left the Euro below $1.18, its lowest since mid-December 2017.
Rising US borrowing costs and a stronger dollar hit hardest in emerging markets, where investors are withdrawing money – particularly from countries with large deficits and big dollar funding needs. Argentina and Turkey are both in trouble. Argentina raised its interest rate to 40% and requested help from the International Monetary Fund and Turkey is struggling with a loss in central bank independence. Emerging market weakness will continue as rates rise and problems could become more widespread. Bonds
Typically, there is an inverse relationship between bond prices and interest rates. Long-term bond prices are not a good place to invest when interest rates are on the up. The 10-year US bond yield reach 3.096% for the first time since August 2008 and has increased nearly 80 basis points in a year. As rates rise we should expect to see a big bear market in bonds. What does the hike mean for traders?
The unpredictable scheduling of rate hikes will create uncertainty. The good news for traders is that as uncertainty increases, volatility increases, and opportunities arise. On the flip side there is also greater risk. A key advantage is to understand the potential benefits and risk and develop a strategy to increase potential while limiting risk.
Higher interest rates increase consumers debt as credit cards, mortgages and retails credits will all increase. A reduction in disposable income reduces consumption and therefore reduces profits of companies. Traders are watching household incomes and spending data along with retail sales. Focus on the Consumer Confidence Index (CCI) to look for signals; recognizing reduced consumption and which products would lose consumers is key as those shares will be hit.
Commodity producers may experience less of an impact from rising real interest rates as they tend to be less volatile than physical commodities. The downside is they have other influencers such as microeconomic factors, corporate earnings or as we’ve seen recently geopolitical threats.
As previously discussed, banks and financial companies tend to perform strongly when interest rates rise as they hold cash on which they earn interest and they can earn more on loans. Although we’ve seen two years of sharp gains, some analysts are expecting more from bank stocks which are believed to be undervalued.
For FX traders the biggest driver is a change in interest rates. The US dollar has been soaring in recent weeks as the markets have grown optimistic about the outlook for the currency. Many investors believe this is down to the interest rate differentials in favour of the US.Bottom line
Interest rates have a distinct impact on the market. A rise or fall affects valuations of different assets and impacts trading activity. Uncertainty in the markets increases volatility which leads to greater risk and opportunity.1http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html