The US Rate Decision (September 2015)

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www.pepperstone.com
Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530
The US Rate Decision:
What to Expect and
3 Possible Surprises

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www.pepperstone.comwww.pepperstone.com
Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530 Risk Warning : Trading Forex puts your capital at risk. AFSL No.414530
Disclaimer: The views and opinions expressed in this article are those of the author alone
and do not necessarily reflect those of Pepperstone Group Ltd. Analysis in this article is based
on limited information and is not provided as investment advice or for education purposes.
Readers should conduct their own research or seek a professional advisor before trading.
On Thursday the 17th September the FOMC will conclude its meeting in which it will
decide on raising US interest rates for the first time in a decade.
In this paper we examine the challenges the FOMC faces in deciding to raise interest
rates in the United States, the process by which they expect to normalise policy and the
potential market impacts that could occur. This event is likely to be one of the largest to
impact financial markets in the last decade, and the ramifications in currency, stock and
bond markets is likely to be dramatic regardless of the exact timing of the first rate hike.
Traders should be aware that the potential for market volatility is extremely high, and
price movements could be well outside of usual daily trading ranges. We hope that this
paper can help prepare traders for some of the possible outcomes, and have a better
understanding of the situation overall. We break down the article in to five parts:
1. An Introduction to the Event – What is this about and when can I expect it?
2. The Current State of the US Economy – Is the economy ready for higher rates?
3. Expected Market Implications – What markets are expected to be most impacted?
4. Possible Surprise Reactions – How the market might get caught off guard
5. Addendum – The Nuts and Bolts of Normalisation – A crash course in economics
An Introduction to the Event
There is an unshakable sense that almost every market and every trader has been
focused on a single critical event this year – the expected first rate increase in the US
for almost 10 years. It is unlikely that a lone 25 basis point increase has ever been so
heavily debated, delayed, rescheduled, anticipated, feared and loathed quite so much
as this one. The debate is lively, in part, because the expectations of the rate rise have
unwittingly helped to push inflation to lows that could shake the resolve of even the
most determined policy hawk; meanwhile, US employment has continued to improve
with the regularity of Swiss clockwork and shrugged off the effects of the commodity
price collapse and rapid US dollar appreciation.
For a central bank faced with a dual mandate to tend to both of
these economic indicators - inflation and employment - it certainly
feels that the Federal Reserve is damned-if-they-do and damned-
if-they-don’t.
The focal point of markets has fallen on the September FOMC meeting - for which
the policy decision and press conference will be held on the 17th of September (from
21:00 server time) along with the committee’s updated inflation and growth forecasts
for the next two years. Before the most recent energy price collapse in August,
markets had become taken with the idea of a first rate increase at the September
meeting; however, as oil prices breached new lows of less than $40 USD per barrel
and China acted to weaken its currency in a surprise move, market expectations have
been trimmed back drastically to around 23% probability for a move this month.

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There is a substantial disagreement between what markets are currently pricing and
what analysts and the FOMC members themselves have indicated for the path of
normalisation. Markets have not priced the first hike until the December meeting,
while economists still expect overall that the Fed could make a move this month - the
divergence between the two makes the potential for a market surprise quite real,
regardless of whether the Fed decides to tighten at this meeting or not.
The FOMC themselves do not get to update their projections of expected interest rates
on a frequent basis, and there is much debate over whether the projections from the
June FOMC meeting will still be accurate when the committee meets in September.
The projections from that meeting are below, and indicate that a large portion of the
FOMC expected more than one rate increase this year – we will not find out until the
September release if that remains the case.
The Current State of the US Economy
The largest hurdle the Fed faces in having a green light to raise interest rates is that
CPI inflation is bordering on deflation - as it has held at around the 0% for several
months this year. The Fed has a target inflation rate of 2%, and although core CPI and
other smoothed measures are holding up better by filtering out energy price declines,
it is not an easy sell to raise interest rates while inflation is near its GFC lows and
market implied inflation expectations are in a steady decline.
Indications from Yellen and other FOMC members are that they believe this
deflationary energy shock will be transient; when the one-off falls in oil prices have
filtered through the year-on-year figures, things will begin to look healthier for
inflation measures. Oil prices first reached the low $40’s per barrel level in early
2015, so barring another major leg down in prices this could see the price declines
pass through year-on-year inflation in the first half of 2016 – allowing for a recovery
towards target from mid-2016 onwards.
When looking at inflation figures, the Fed may try to look ahead by around 12-18
months – which is the time many believe it takes for monetary policy to begin to
work on the economy. Because of this time consideration, the FOMC may be willing
to ignore or ‘look through’ the falling prices that are seen now, as long as they are
‘reasonably confident’ that inflation will begin to return to target over the next 1-2
years.

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Another consideration that the FOMC have made is around the pace of tightening,
which may be affected by the start date for lift-off. Previously, Janet Yellen has
indicated that a gradual rise in rates is preferred, implying an earlier first hike and
a gentle pace of increases so as not to shock markets too much. The reason for
caution here is that if the Fed instead waits until inflation has returned to target,
or overshoots it to the upside, then they may be forced to raise rates rapidly to
prevent inflation getting out of hand – having the potential to cause a large amount
of financial stress and another credit crunch. FOMC member Eric Rosengren
suggested in a speech this month that FOMC expects tightening to occur at around
half the pace of the previous cycle in 2004.
The second part of the Federal Reserve’s dual mandate is to promote
maximum employment; on this measure the Fed is on track to succeed, with
the unemployment rate almost back to what it considers the natural rate of
unemployment. As of the last reading this month, unemployment is back to
5.1% and the CBO’s long term natural rate of unemployment is estimated to be
approximately 5% - using these measures the employment recovery appears to be
nearly complete.
What may give the FOMC confidence to raise interest rates is that, as the slack in the
labour market is taken up and the economy nears full capacity, wage pressures will
begin to grow in the labour market to help support inflation’s return to target. Wage
growth has been fairly anaemic since the GFC, which may be partially explained by
wages being ‘sticky’ downwards – meaning that employers are reluctant or unable
to cut wages by as much as may be warranted under the economic circumstances
– causing an additional slack in wage pressures that needs to be taken up; if this is
correct, wage pressures and inflation have been further delayed by the need for
the difference between nominal wages and the true value of labour to be absorbed.
If the economy is starting to reach full employment, then wage growth may finally
overcome this barrier and materialise to end the era of low inflation.
Other measures of economic health seem to indicate that the US economy is
reasonably healthy. GDP growth and cyclical measures such as industrial production
are growing despite scepticism about the upcoming tightening. Real GDP growth is
now comfortably in the 2-3 percent range which, while not booming, is a fairly healthy
rate of growth.
If FOMC members are correct in their belief that inflation will return to trend, then
most other measures of the real economy would give them a green light to go ahead.
What is still very much up in the air is how markets will handle the tightening cycle.
Stock markets have benefited from an era of very accommodative policy that has
allowed price-earnings multiples to climb in recent years; whether the removal of this
accommodation will take the wind out of the stock market’s sails is something that is
in the front of many investors’ minds.

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Expected Market Implications
The expected effects of a US tightening cycle are already evident in various pockets
of the global economy, including declining commodity prices, financial stress in
emerging markets, US dollar strength and increasing market volatility. Expectations
are that, should the Federal Reserve continue to tighten in the current environment,
stress will continue to build in these other parts of the world even as the US
economy powers forward. While so many markets are affected by the Federal
Reserve’s policies, the central bank may not be able to ignore its own domestic
situation in order to make things easier for foreign economies.
In a situation where the Fed embarks on a tightening cycle out of
step with a sluggish global economy, the divergence in economic
prospects could continue to heavily affect economies tied to
commodities and those who have borrowed in US Dollars.
In a situation where the Fed embarks on a tightening cycle out of step with a
sluggish global economy, the divergence in economic prospects could continue to
heavily affect economies tied to commodities and those who have borrowed in US
Dollars. China, who runs a loose peg to the US dollar, may be forced to devalue
further and break its strong ties to the dollar in order to save its own economy. A
weakened Yuan could depress Chinese commodity demand from external sources
even further. One consequence of this currency weakening, or liberalisation, could
also be for China to offload its foreign exchange reserves to slow the Yuan’s descent
to a manageable rate – reducing its reserve buffer against a currency crisis in the
future.
With these effects in mind, it is easy to envisage of a feedback loop that sees
emerging markets in particular facing terrible economic pain. Commodity price
declines could further depress emerging market economies and exacerbate
currency weakness against the US dollar; if those economies have large exposure
to US Dollar denominated debt, then funding issues could be the next domino. In
the past when the value of foreign debt service increases with the exchange rate,
emerging markets have typically run in to debt or currency crises. The situation
could be a cornucopia of economic malaise, before even considering that some of
these economies could also have burgeoning housing bubbles – such as commodity
exporters Canada and Australia.
Possible Surprise Reactions
The expectations from the previous section are very much ‘known unknowns’, and
the market should have at least attempted to price in the direct and indirect effects of
the first rate rise. Further continuation of the economic dislocations of 2014 and 2015
as a result of US outperformance are likely to depend on the pace of subsequent
rate increases and the ultimate peak of the tightening cycle. If the market has
underestimated how rapidly the Fed will tighten, then more of the same could be in
store for battered energy and commodity producers.
We have already had a preview of the effects for an unexpectedly swift US policy
normalisation over the last 12 months, and the media is full of negative speculation
about the prospects for non-US economies as a result. With most being aware of the
potential dangers of this tightening cycle, it may be more constructive to think about
what could happen if the hype and anticipation that has been generated over the last
12 months has caused people to overestimate the effects of a US tightening. Here are
some contrarian scenarios to balance out the debate:
Surprise 1: The market reacts in a risk off manner, but the US Dollar is not the
chosen safe haven
People might still be scratching their heads as to why the US dollar sold off from
August 19th to the 25th, in tandem with stock markets worldwide. It seemed almost
as if the US was no longer the safe haven of choice as it has been for much of the
time since the onset of the GFC. One theory to explain this unexpected move is that
of the transition between how the US dollar – and indeed the Euro and Yen – are seen
as funding currencies.

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Through the wake of the GFC, when the US held rates at zero and performed
multiple rounds of quantitative easing, the US Dollar became a ‘funding currency’
for risk positions or carry trades; funding costs were low and expectations were that
the US dollar would continue to weaken against stronger economies currencies.
As US prospects have improved over the last two years, sentiment has shifted
positively towards the country - even more so now that the country is expected
to enter a tightening phase – and use of the US Dollar as a funding currency is
considered to be a much riskier proposition.
At the same time, across the Pacific, Japan was moving the Yen deeper in to its
place as a funding currency; ‘Abenomics’ saw the country embark on a very large
scale program of Quantitative Easing - which would then be expanded in October
2014 – leading to a persistent currency depreciation. Across the Atlantic, Europe
was putting together the makings of an asset purchase program and another series
of LTRO programs to stimulate the economic bloc. As one of the easing measures,
the ECB also moved interest rates in to negative territory for the first time – all but
cementing the Euro as a funding currency for risk positions due to a low cost of
funding. The Swiss Franc finds itself in a similar position now that interest rates are
also firmly negative at -0.75%, though with the dramatic moves in the Franc this
year the currency has been treated with more caution than the other two.
A funding currency will often lose value during good times as risk positions build up
using the currency as the source of funding – traders are short the funding currency
and long risk assets; this is commonly known as a carry trade in FX, and it has the
unfortunate consequence of unwinding rapidly when market sentiment turns sour –
similar to how margin debt is rapidly reduced when the stock market crashes.
Interestingly, despite the US economy being generally considered the economy with
stronger economic prospects, unwinding risk positions can mean that currencies
such as the Euro, Yen and Swiss Franc act as the stronger safe havens. Given this
explanation, it is no surprise that the August stock market crash was accompanied
by strength in these currencies and a substantial ‘short squeeze’ of the positions
built up in the US dollar. The Dollar found itself part of a broader group of risk
currencies that sold off heavily, in a reaction that caused much surprise. A
tightening cycle should theoretically move the US Dollar further away from a
position as a funding currency. Most recently the US dollar fell in lock-step with
stock markets:
The surprise reaction in this scenario is that the rate hike is taken by the market in a
risk-off manner, causing a stock market selloff in the US as well as abroad. If the new
paradigm of the Euro and Yen as funding currencies holds firm, then a stock market
rout could actually see a surprise appreciation in these two currencies and a mixed or
negative reaction for the US Dollar. With US Dollar positioning at extreme levels this
could be quite explosive.
To some extent this reaction depends on how dependent market valuations are
on monetary policy, or how risk sentiment reacts to monetary policy. In some
prior cycles, the stock market been driven by strong economic growth – the horse
(economy) pulling the cart (stock market). Sometimes it is sentiment that pulls
the market higher, or even the market gains themselves that encourage further
speculation. One example of this would be the 1990’s tech boom, where much of
the gain was price-earnings multiple expansion rather than purely earnings growth;
in this situation it is the cart (stock market) pulling the horse (economy) whether it
chooses to follow or not. Was quantitative easing and ZIRP the market’s good news
story, or was the strong rebound in the economy the main driver of the markets?
Surprise 2: The big question – is it already priced in?
So often in markets when everyone expects one thing to happen, the opposite occurs.
Markets are constantly surprised when the obvious is suddenly so obviously wrong.
Examples of this litter the recent past, can you remember what you were thinking
would happen next in the lead-up to the major announcements below?

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Quantitative Easing: The general consensus from analysts and economists was that
long term interest rates were going to fall when QE started due to the Federal Reserve
buying such large quantities of bonds. When the programs started, yields jumped
higher in a counterintuitive reaction (red), but began mysteriously dropping each time
the Federal Reserve stopped buying bonds and exited the market (blue):
Tapering: in a similar vein, when QE ended there were fears that the lack of demand
for bonds would see yields rise and cause trouble in loan markets and for US debt
service. Surprisingly, yields fell quite consistently from the moment the Fed tapered,
and continued falling even after it completed the tapering process (yellow, above).
QE 2: When QE 2 was to be announced, there were expectations that it would cause
another period of US dollar weakness and it was often regarded as ‘printing money’. In
another counterintuitive move, the dollar sold off against currencies like the Euro right
up to the day of the announcement, and then without obvious reason reversed course
and strengthened for months afterwards:
European QE: As recently as this year, there was near consensus that it was a matter
of when, not if, the Euro would plummet past parity with the US Dollar as the market
built up expectations for a QE program from the ECB. Negative sentiment towards
the Euro reached fever pitch in March this year, when QE finally began and the ECB
began creating Euros to buy up assets. After falling for the first couple of days of the
program, the Euro has been remarkably resilient since QE started, and it may take an
expansion of QE or a sustained US tightening to move it lower.
In most of these cases, the market had already priced in the
effects of the monetary policy change before it began. Once the
policy changes were announced this signalled the end of the
journey for a lot of traders.

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The problem could well be that, in most of these cases, the market had already priced
in the effects of the monetary policy change before it began. Once the policy changes
were announced this signalled the end of the journey for a lot of traders, and their
positions being closed out caused a counterintuitive market reaction. The question of
how much of the tightening cycle is priced in will be at the forefront of many trader’s
minds when it comes to the FOMC announcement.
Surprise 3: Currencies and Stocks React Explosively
US Stocks: US stocks are one asset class that has moved in a single direction for several
years. Even August’s rapid sell-off ranked quite low in terms of historical market
declines, and markets have since recovered around half of the drop. By a number of
measures, US stocks are in the upper end of market valuations globally – with many
believing the easy monetary policy of the last 6 years has been responsible for building
up a speculative fever and appetite for risky assets. Stock market bears, having been
burned by the rally have gone quiet in recent months; if they get a sense that the
market is finally turning they could come back in a big way.
The Australian Dollar: The AUD reached a post-crisis low value of 69 cents against
the US Dollar last week – a massive fall from grace after breaching the $1.10 level
back in 2011. Even if our first surprise were to occur and the US dollar was sold off
during a market crash – this does not mean that the AUD can only go up. There is a
chance that both currencies sell off, and the AUD continues to fall relative to the US
dollar. However, if US dollar positioning does unwind and that ends up supporting
commodities – the AUD could be one surprise beneficiary of a relief rally.
The Euro and Yen: As funding currencies outlined earlier, these both do have a lot
of potential to benefit from a risk off movement. The Euro in particular is one where
the markets position is overall very short, though not quite as short as when QE was
announced by the ECB. Both stand to move violently on any risk position unwinding,
however both also have inherent risks as there is suggestion that both the ECB and
the BoJ could expand their current QE programs in the near future to counter the
deflationary shock of falling oil prices. A risk off rally in these currencies could be
short lived if it spurs their central banks in to further easing action.
With markets and analysts still split down the middle over which way the Fed will
go at this meeting, one side will turn have to be wrong at the end of the day. This
divergence in opinions means that while the market may have tried to price in the
rate change, it may still get caught out on the timing of the move – so a move this
week, or even a delay to the first move to a later date by the Fed could both surprise
the market, it will just be a different section of the market that is surprised. Traders
may want to make sure they are prepared for the announcement by checking
positions and ensuring there is enough margin available in their accounts for any
open positions or new trades.
If you are interested in the mechanics of how normalisation will work, please read on
to the Addendum.

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Addendum - The Nuts and Bolts of
Normalisation
When the Fed does decide to raise rates, this tightening cycle might look a little
difference to the last one. Since the onset of Quantitative Easing, the multi-trillion
dollar build-up of excess reserves has had some unintended consequences that mean
new mechanisms will need to help the Fed set an interest rate range; the Fed will also
need to decide when to stop reinvesting maturing bonds and allow its balance sheet to
deflate.
In the Federal Reserve’s 2014 document Policy Normalization Principles and Plans they
outlined the procedure that will form the normalisation process:
1. When economic conditions and the economic outlook warrant a less accommodative
monetary policy, the Committee will raise its target range for the federal funds rate
2. During normalization, the Federal Reserve intends to move the federal funds rate into
the target range set by the FOMC primarily by adjusting the interest rate it pays on
excess reserve balances.
3. During normalization, the Federal Reserve intends to use an overnight reverse
repurchase agreement facility and other supplementary tools as needed to help
control the federal funds rate. The Committee will use an overnight reverse repurchase
agreement facility only to the extent necessary and will phase it out when it is no longer
needed to help control the federal funds rate.
Explaining these steps in detail requires going in to a little more technical detail about
the challenges the Federal Reserve faces in raising rates – those brought on by the
excess reserve balances in the banking system.
Bank reserves are a bank’s deposits held in their accounts with the central bank;
reserves are generally required for the purpose of holding as security against any
loan the bank makes, and the amount required is typically controlled by the reserve
requirement ratio. ‘Excess’ reserves are those held above the amount required by a
bank’s reserve requirement. Since 2008, the large excess balances are a direct side
effect of banks intermediating the sale of bonds to the Federal Reserve during the QE
programs it ran from 2008 to 2014.
Holding excess reserves was not a conscious choice by banks, but an unavoidable
effect of having the Federal Reserve pay for the securities purchased under QE with
Reserve Balances, which it does by expanding its balance sheet. Effectively, the Fed
creates reserves from thin air to purchase an asset (in this case a Treasury bond)
from a bank and in doing so creates a liability on its balance sheet (the reserves it
pays the bank with). Because the reserves that banks receive in this process are not
attached to any loan, there is no reserve requirement involved and they become
‘excess’ reserves.
The banking system can do little to get rid of the reserve balances in aggregate, and
only banks themselves can hold reserves – meaning these excess reserves serve little
real purpose for the broader economy. If left to their own devices, banks would seek
to get rid of these reserves by lending them at progressively lower rates to other
banks until the overnight rate reached zero, as any return is better than none. To
counteract this massive downwards pressure on the overnight federal funds rate,
legislation was changed to begin paying interest on excess reserves (IoER). IoER is
intended to form the new lower bound of interest rates, as banks should have no
incentive to lend out their reserves at any rate lower than the risk free interest rate
paid on them – alleviating the downwards pressure and giving the Fed more control
over raising rates while excess reserve balances exist.
Unfortunately, because not all participants in money markets can hold reserve
balances, the payment of IoER is not quite enough to set a firm floor on the overnight
rate. Banks theoretically can earn an arbitrage profit by borrowing in money markets
at any lower rate than IoER, and then earn the IoER rate from holding reserves with
the Fed, which should make the floor hold by bidding up short term borrowing
rates to the same level as IoER. In reality, this arbitrage is not costless due to capital
requirements and other costs incurred by banks, so there can be a divergence
between money market rates and the IoER rate set by the Fed to place a floor on
overnight rates.

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Chris Hewitt is a market commentator and part of the
currency analyst team at the Melbourne headquarters of
forex broker Pepperstone.
Chris has a Bachelors degree in Economics specialising in
monetary policy, and has been trading and following a range of
markets for 5 years.
With these excess balances conspiring to make it difficult for the Fed to raise short
term interest rates to a desired level, it set about looking for a way to involve a broader
range of counterparties in its setting of the overnight rate – including a range of money
market funds and government sponsored entities that are not depository institutions,
but for whom dealing in money markets is a necessary part of business. Enter the
Overnight Reverse Repurchase Agreement (ON RRP), which can be used with the new
broader range of ‘eligible participants’.
RRP’s are a tool that the Fed has been trialling as a supplementary measure to IoER
in setting the Fed Funds rate. A reverse repurchase agreement works in the following
manner:
1. The Federal Reserve will offer to sell a security from its balance sheet to eligible
participants, with the promise to buy it back the following day at a set price.
2. When the Federal Reserve repurchases the same security the following day, it does
so at a slightly different price to the sale price.
3. The difference in price represents a yield to the participant that can be used to set
a floor under short term interest rates, because there should be no incentive to
lend below this risk free interest rate.
4. The Federal Reserve offers US Treasury securities as its RRP collateral, which it
accumulated during QE.
The ON RRP would form the floor on an interest rate range, as expanded
counterparties would not have an incentive to lend below this rate. The IoER rate would
form the upper ceiling of interest rates – together they would allow the Fed a stronger
degree of control, however FOMC members intend the ON RRP to be used only as-
needed and to hopefully be phased out as soon as possible once rates are at a more
normal level.
The other part of the normalisation process – reducing the size of the Federal Reserve’s
balance sheet - will not follow at least until the first rate increase is out of the way. As
the Fed explained in its normalisation principles:
1. The Committee expects to cease or commence phasing out reinvestments after it
begins increasing the target range for the federal funds rate; the timing will depend
on how economic and financial conditions and the economic outlook evolve.
2. The Committee currently does not anticipate selling agency mortgage-backed
securities as part of the normalization process, although limited sales might be
warranted in the longer run to reduce or eliminate residual holdings. The timing
and pace of any sales would be communicated to the public in advance.
It is expected that at first, when the Fed believes the time is right, it will end its
reinvestment policy as its first step. This policy has up until now seen the Fed reinvest
maturing security proceeds back in to the market in order to keep its balance sheet
steady. By ending reinvestment, the size of the security portfolio held by the Federal
Reserve would begin to decrease through a natural decay over time, without putting
any unnecessary strain on market rates by directly selling its securities.
Indirectly, the process of ending re-investment is considered a form of monetary
tightening – as it increases the supply of securities on the market, meaning longer
term interest rates may move higher than they would under a continued policy of
reinvestment. Because this policy change could result in an opposite effect to QE
(higher long term interest rates) the Fed is expected to wait until it is certain the
market can handle it, which could potentially be a year or more from when it first
raises rates. The Federal Reserve estimates it could take around 7 years to normalise
policy.
Disclaimer: The views and opinions expressed in this article are those of the author alone
and do not necessarily reflect those of Pepperstone Group Ltd. Analysis in this article is
based on limited information and is not provided as investment advice or for education
purposes. Readers should conduct their own research or seek a professional advisor
before trading.

20 21
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The US Rate Decision (September 2015)

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