I’ve said it a few times this year, so you would be perfectly within your rights to discount a repeat, but the events of this week are huge and could potentially shape how 2016 turns out for the macro world. The FOMC decision will not only impact US lenders and borrowers, but emerging market corporates, political events around the world and the economic well-being of billions of people. This all sounds very dramatic, but I can find no better analogue for the upcoming event than the interest rate rise in February 1994, which was followed by more rises throughout 1994. History suggests that this was one of the major contributory factors which led to the Mexican peso or Tequila crisis (http://www.frbatlanta.org/filelegacydocs/J_whi811.pdf). I’m certainly not suggesting disaster for Mexico this time around, but it would not be a surprise to see calamity somewhere else in the world. There are so many economies which could be classified as highly vulnerable to a US rate rise: Nigeria, Russia, Brazil and even China are but a few of the larger, systemically more consequential emerging economies, but they are far from alone. If this is the case, then why would America’s Federal Reserve risk such disaster? Well.. for a start, looking after mismanaged economies around the globe is not a part of their mandate! Furthermore, there is the other risk… what if they don’t start hiking now and inflation rears its ugly head? In this scenario, the terminal rate for the hiking cycle would be much much higher than it needs to be. No.. in my view, a rate rise now is a good thing. Quite apart from the completely distorted signals businesses currently face in determining their cost of capital, action now will virtually guarantee that the terminal rate at the end of a tightening cycle will remain fairly low.
I would guess-timate the likelihood of a rate rise on Wednesday to be in excess of 90%. The Federal Reserve could quite easily have hiked in September, but they held off largely because of significant China related market volatility. There is no such excuse this time, and indeed the US central bank would be at risk of losing its credibility if they took no action after continually warning the markets that a rate rise is imminent. What happens afterwards in the currency market is now the subject of considerable debate in the macro community. As we approach Wednesday the dollar has stalled somewhat, so it is entirely understandable for some traders to expect a counter-trend move, dollar weakening, to follow any rate rise. But there is also a risk that the Federal Reserve will state its intention to persist with more tightening rounds in 2016 following this first hike. If that happens then expect the dollar to rally strongly. The conditions have been created for this because positioning has been reduced dramatically following the disappointing ECB monetary policy meeting. This is the key thing to watch for on Wednesday, not the hike itself, but what the FOMC says about its future plans. If you have dollars to trade, don’t gamble either way, the moves could be quite large, the best way to mitigate the risk of being caught on the wrong side of a big dollar move is to do some of your transaction now and hope for a move that improves your average. Good luck!
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