Markets Have to Adjust as Fed Alters Course

Markets, Have, Adjust, Fed, Alters, Course, Fundamental Anlysis, fx trader, forex

23 May 2016

The Fed’s normalisation process has been a tortuous on/off affair primarily because their focus has been almost entirely on not upsetting the financial markets rather than doing the right thing for the long term health of the US economy. This week, the Federal Reserve machine cranked into action to persuade markets that they want to raise rates before the Summer and again before year end. So far, the reaction has been quite muted, but it is far from certain that this calm veneer will continue. Let’s dive in and think about what the Fed are doing and what this means for markets.

We have little doubt that a truly independent Fed would realise that their policy setting is just plain wrong in terms of the domestic economy. It has been wrong for years now, and we know why this is so. The Fed is continuously worried about upsetting financial markets if they remove the punch bowl. They are also now worried about Dollar strength, vulnerable global growth, low commodity prices and political  uncertainties. Despite the rally in asset prices in the last two months or so, none of these uncertainties have actually been resolved, and so it is unclear why the Fed have altered their narrative this week, especially ahead of the G7 meeting next weekend.

Whatever the reasoning for the alteration in policy, more rate rises than previously expected by markets will have an effect on prices. The most sensitive to faster rate rises will be the front end of the US yield curve, and probably the US Dollar as policy divergence becomes more obvious again. Chart 1 below plots the Fed Funds mid point versus 3 month Libor and the two year Government bond yield. What is clear is that prior to the rate rise in December, US interest rates were already rising in anticipation. At the moment, the market has barely begun to price in a second rate rise, never mind a third or fourth. We expect short end US rates to rise assuming the Fed can deliver on rate rises.

1 Markets, Have, Adjust, Fed, Alters, Course, Fundamental Anlysis, fx trader, forexChart 1 – Short end US interest rates versus Fed Funds