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By Oren Laurent
President, Banc De Binary
The Fed decision following the September 16-17 FOMC meeting was expected by some, and roundly criticised by many others. Whether or not the decision was the correct one has to be viewed in context of the larger global picture. That the Fed decision is supposed to take US domestic economic conditions into account was put aside in this particular instance as a result of global economic weakness. The International Monetary Fund (IMF) cautioned central banks around the world not to raise interest rates at this critical juncture. Massive uncertainty remains following the equities meltdown in China, where trillions of dollars was wiped off the Shanghai Composite index and the Shenzhen Index in August. This plunged European and American bourses into a tailspin, and the current market predicament is best described as precarious.
The 12 member FOMC and Board of Governors at the Federal Reserve decided almost unanimously (with one dissenting voice) to adopt a dovish tone and stick with the short-term interest rate at current levels 0%-0.25%. This has far-reaching implications for market sentiment, and multiple asset categories which will be impacted by the decision.
Following the Fed decision announcement on Thursday, September 17, US indices plunged. This seems counterintuitive given that equities markets in the US should embrace low interest rates. Had there been a rate hike, the cost of borrowed money would have increased, leading to sharp declines in company profits, earnings per share and dividends paid out to shareholders. This did not happen, yet equities markets plunged. The reasoning behind the sharp sell-off in US equities is perhaps best explained by the expectations of stakeholders in the market.
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The biggest losers on Wall Street were banks, financial institutions, asset managers and the like. They were expecting windfall profits from their customers and investors in the event that the Fed hiked interest rates by the anticipated 0.25%. Had this happened, billions upon billions of dollars in added revenue streams would have been generated by banks, with more interest earned on mortgages, long-term loans, credit facilities, etc. As a result of no changes being made, sharp selloffs in this sector took place, and dragged down the Dow Jones, NASDAQ and the S&P 500. The S&P 500 dropped 1.6% to 1,958.03, the Dow Jones dropped 1.7% to 16,384.58 and the NASDAQ composite index dropped 1.4% to 4,827.23. Remember that banks and financial institutions comprise a large percentage of the overall value of Wall Street bourses. But it wasn't only US bourses that suffered, the FTSE 100 index dropped 1.34%, the DAX dropped 3.06%, the CAC 40 dropped 2.56% and the IBEX 35 slid 2.57%.
So why did the Fed decide not to hike rates?
Besides the IMF cautioning against a rate hike, the Fed was more concerned with two important elements:
– US core inflation is currently 1.2% and the Fed is targeting an inflation rate of 2% before it hikes interest rates;
– Global weakness continues to dominate, led by sharp contractions in the performance of the Chinese economy.
That the Fed is concerned about the state of Chinese stock markets, and the Chinese economy at large is especially notable. What many analysts considered to be a region-specific problem is now being viewed as an issue that has the potential to upset the global economic balance. In other words, the problem in China has to be contained and nobody wants to create greater uncertainty by raising interest rates at this time.
Here’s what would have happened had the Fed raised interest rates. The USD would become more desirable vis-a-vis a basket of currencies. This would strengthen the dollar and weaken currencies that were being traded for the dollar. Ultimately, this decision would hurt US exports, which would lead to contractions in US economic performance over the long-term. While a strong US dollar allows the US to purchase more foreign goods and services, this would upset the balance of trade and be detrimental to US economic growth.
Another issue is that of emerging market currencies. Capital flight continues to leave Brazil, Russia, China, India and South Africa en masse. The decision not to hike interest rates initially led to a strengthening of emerging market currencies, but all gains were given back as anxiety returned to the speculative market. The Fed did not rule out a rate hike in October, November or December. Therefore, emerging market countries have won the battle, but not the war. Speculators have capitalised on this pervasive anxiety among traders, sending currencies like the South African Rand, Turkish lira, the Brazilian real and others into a downward spiral.
What asset categories benefit from the Fed decision?
During times of market uncertainty, the one asset class that always benefits is gold. And this is precisely what happened in the run-up to the Fed decision and in post decision activity. As mentioned, equities should rally when interest rates are low, but they didn't in this case. The reason is that there is tremendous uncertainty in the markets especially now that the Fed was unable to make a domestic decision because of weakness in China. This shows that US stock markets are more vulnerable than what many traders and investors believed. Equities markets do not like uncertainty, and weakness in banking and financial stocks drag markets lower. It also doesn't help that the Fed alluded to hiking rates before the end of 2015.
Nobody wants to plough money into the equitiy markets if they think that interest rates are going to rise within the next couple of months. Gold is a non-interest-bearing asset. This precious metal, along with platinum and silver, spiked following the Fed decision. Gold for delivery in December increased by 1.9% to $1137.80 per ounce, and the weekly gain in the precious metal was 3.1%. Remember that the demand for gold is inversely related to the strength of the dollar. An interest-rate hike would strengthen the USD and send gold reeling.
Now you're likely to see a mini rally in the price of gold, but large selloffs will possibly take place closer to the next Fed policy meeting.
Please note that this column does not constitute financial advice.
