In one of the most telegraphed and long-awaited interest rate hikes in history, overnight, the US Federal Reserve bumped up the Fed funds rate by 25 basis points.
The Wall Street Journal has the story…
‘The Federal Reserve said Wednesday it would raise its benchmark short-term interest rate for the first time in a year and expects to lift it faster than previously projected in 2017.
‘Fed officials said they would nudge up the federal-funds rate by a quarter percentage point on Thursday, to between 0.50% and 0.75%, a move that could cause other household and business borrowing costs to rise as well.
‘They also indicated they see a brightening economic outlook and expect to raise short-term rates next year by another 0.75 percentage point — likely in three quarter-point moves.’
Hmmm…that sounds a lot like the optimism which surrounded the December 2015 rate hike.
But it didn’t quite work out like that.
Instead, we got plenty of ‘we’ll just hold off until next month’ rhetoric — until next month turned out to be 12 months later…
But, who knows? Perhaps the Fed really will get some traction next year; maybe it will be able to raise rates three more times. I can only see this happening in the event that inflation starts to pick up strongly.
Don’t forget, the Fed’s interest rate is a nominal rate. To get the ‘real’ rate, you need to subtract inflation. So, if inflation picks up at roughly the same rate as the Fed increases nominal official interest rates, then real rates haven’t moved at all, and there is no monetary tightening going on.
That’s only my view, however. The evidence suggests that, at this point, the market is pricing in some monetary tightening. You only have to look at the gold price to see that.
Overnight, gold fell to US$1,145 an ounce, the lowest point since February this year. Gold is down nearly 20% over the past few months. The selloff started after the market became increasingly confident that the Fed would raise rates in December and keep going with the rate hikes into 2017.
The fact that Donald Trump won the election was, ironically, a negative for gold. Trump’s growth agenda is good for the economy, which, in turn, means there is less reason to hold gold. Clearly, capital is pouring back into the equity market — and cyclical stocks in particular.
So, while US stocks sold off overnight on the Fed’s decision (the Dow fell 160 points), it’s little more than a case of buying the rumour (of interest rate rises) and selling the fact.
Have a look at the chart of the Dow below. The surge since the Trump election victory has been quite incredible. And it’s not as if the Dow was coming off a major low or anything. It was in the process of correcting a move to a new all-time high when the Trump victory acted like a slingshot for the index.
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That the market rallied into an expectation of a rate hike tells you that the economy is strong enough to handle it. The selloff overnight shouldn’t be seen in a bearish light. It is simply an excuse for profit-taking after a strong run.
The biggest problem the Fed will have next year is in taking the strength of the US dollar into account. The dollar index, which measures the greenback against a basket of major trading partners’ currencies, is at the highest level since 2003!
Given the issues facing the rest of the world, capital is clearly flooding into the US. Capital goes to where it can earn the highest return and, compared to the UK, Europe, Japan and China (too hard and too risky), the US dollar is the only currency game in town right now.
The Aussie dollar understood this reality overnight. It dropped by 0.6% on the Fed announcement. You can see a chart of the Aussie/US dollar exchange rate below. The Aussie looks quite weak. After falling sharply in November, it rallied weakly in December.
But it has hit resistance (marked by the green line), and now looks like it’s in the process of turning back down. I wouldn’t be surprised to see it continue dropping in 2017.
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That’s because, while the Fed looks to increase rates in the US, the RBA will, at best, sit on its hands for the first few months of 2017. The domestic economy is weak, with household spending flagging over the past few quarters, despite the East Coast property boom apparently inflating household wealth.
Until wages growth picks up, or household spending accelerates again, the RBA won’t be raising rates. In fact, they will be hoping the dollar does continue falling. A weaker dollar exerts some stimulus on the economy (or at least certain parts of it), and the RBA would prefer that to another interest rate cut.
But let us not get too carried away with the US economy, either. It doesn’t operate in isolation. The Fed may set interest rates for the US economy, but the US dollar is a global currency. Its rise to 13-year highs is not good for many economies.
In particular, China and emerging economies in general have struggled with a strong greenback in the past. Remember the volatility in mid-2015 from China devaluing the yuan? And the global panic in early 2016 following the Fed’s December 2015 rate hike?
If you’re looking for a repeat panic in early 2017, you’re likely to be disappointed. Markets don’t work like that. The same record never plays twice. It’s always a remix. A different version of the same song…
In other words, this rally could surprise nearly everyone and keep on going.
For The Daily Reckoning
PS: Our colleague Callum Newman recently interviewed former News Corporation and Fairfax journalist Michael West.
You can hear the interview on Callum’s podcast, The Newman Show. As Callum told me, West talks about how newspapers are dead, business journalism is a joke in Australia, and no one takes on big end of town.
It’s sure to be an interesting episode.
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