What to expect as the Federal Reserve decision nears

What to expect as the Federal Reserve decision nears

The Federal Reserve is set to raise rates for the first time in nine years this month. How could the Fed’s decision affect markets and politics as the world moves into 2016?

On December 15th, the Federal Open Market Committee will begin a two-day meeting that will result in a widely anticipated policy decision on the central bank’s key interest rate. An increase is likely as futures markets indicate a 79% probability of a rate hike to 0.50%.

After years moored in the safe harbor of zero-interest rate policies sought during the throes of the 2008/2009 financial crisis, Fed Chair Janet Yellen has indicated the US economy is finally sturdy enough to set out on a new course towards normalized rates. Considering the tight correlations and interdependencies across the global financial system the Fed will not set sail into a vacuum. Instead, the departure is sure to have market and political ripple effects on shores near and far.

Domestic Dispute

Domestically, the Fed risks raising rates too early and being met with deteriorating economic activity over the first half of 2016 as a result. The act of increasing interest rates often reduces money supply and serves as a drag on GDP growth. Already, the latest reading of the ISM Manufacturing Index fell below 50.0 for the first time in 36 months, denoting a contraction in manufacturing activity.

Presently US equity markets sit near all-time highs on the presumption of solid growth and a responsive Federal Reserve, but if the downturn in economic indicators were to become a trend and weigh on forward GDP growth in the face of tightening monetary policy then equity market valuations would feel the pressure as well.

US corporate debt will also be susceptible to headwinds in an environment of rising rates because such debt then becomes more expensive to service. This is unwelcome news for the US energy industry as declining oil prices have already put high-cost producers, especially the fracking sector, on the ropes financially. Even now, high-yield bond prices are at levels usually associated with a recessionary environment.

Energy debt represents at least 15% of the entire junk bond market so any further increases in borrowing costs for such stressed companies risks a credit crunch as depressed revenues fail to keep up with elevated borrowing costs. After all, the last such crisis originated in the sub-prime housing debt market under similar circumstances despite assurances by then Fed Chair Ben Bernanke that there was little risk of contagion.

The Race

The potential for unintended consequences from a rate hike will also coincide with the home stretch of the 2016 Presidential elections. If capital markets and the economy do not adjust well to the telegraphed monetary policy shift, the incumbent Democrat Party and frontrunner Hillary Clinton will find it even more difficult to cite stock market highs and steady growth in jobs and output as reasons to send the former Secretary of State to the Whitehouse next November.

The large Republican field of Presidential candidates is sure to seize upon the growing influence of the Federal Reserve no matter which decision the FOMC makes on interest rates this month. In fact, if the committee was to determine that domestic economic conditions and international variables were too fragile to raise rates at this time and again delayed an interest rate hike then Republicans would likely pounce on the opportunity to frame current policies as ineffective, if not damaging.

The Republicans make no secret of their unease with what they perceive as the Federal Reserve’s outsized influence on financial markets, ballooning balance sheets, and arbitrary decision making processes. Two Republican candidates for President, Senators Rand Paul and Ted Cruz, have co-sponsored legislation that would audit the Fed and issued support for the more comprehensive Fed Oversight Reform and Modernization (FORM) Act of 2015 that just recently passed the House of Representatives. If the Fed missteps one way or the other in December, expect more criticism of the central bank from these Presidential candidates and building support for such reform measures.

Global Divergence

Despite the Federal Reserve’s ‘Dual Mandate’ focus on domestic inflation and unemployment, the most potent effects of a decision on benchmark interest rates may fall on international companies and economies. A shift to increasing US interest rates will tighten money supply and lift the value of the dollar relative to other currencies; compounding an already yawning divergence between them.

This divergence has emerged as the Fed moved away from stimulating policies just as central banks in Europe, Japan and elsewhere maintained or even doubled down on such measures. An interest rate hike by the Fed now would only worsen this split, creating a stark contrast between rising rates in America and Europe’s zero-rate or negative-rate policies – making the dollar even stronger.

For companies that carry debt denominated in US dollars, but earn a significant portion of their earnings outside the US, the threat to balance sheets posed by a runaway dollar is severe. Independent of business fundamentals, debts will become more expensive to pay as the dollar climbs and foreign currencies weaken amid slowing growth abroad.

A prime example is Petrobas: US Dollar denominated debt makes up 70% of the total debt load carried by the Brazilian oil company currently mired in scandal. Revenues for energy and mining issues have already tanked as commodities such as oil and copper sit at multi-year lows. Making matters worse, the Brazilian Real has plunged during what Goldman Sachs has deemed an ‘outright depression’ enabling debts denominated in US dollars to become crushing.

The tumult has spread throughout the world’s 7th largest economy, leading to impeachment proceedings of Brazil’s President Rouseff and raising the risks of sovereign debt and political crises across South America – all with the current zero-rate policies of the Federal Reserve. With an interest rate hike, the Fed dramatically increases theses risks and a potential repeat of the 1980’s Latin America debt crisis.

From domestic economic activity and US Presidential politics, to foreign currency divergence and international political disruption – the ripple effects of the Federal Reserve’s long awaited voyage will circle the globe. Even with years to prepare, investors and stakeholders would do well to observe the gathering storm clouds on the horizon and take precautions.

Categories: Economics, North America

About Author

Jeffrey Moore

Jeff Moore is a Project Manager and Research Specialist with the North Carolina Department of Commerce, with a focus on legislative, economic and workforce issues. Previously, he served in the Office of Governor Pat McCrory as an economic policy aide and researcher. After earning a BA in Political Science from the University of North Carolina at Chapel Hill in 2007, Jeff worked as a proprietary equity trader, successfully navigating capital markets during the 2008 financial crisis and the ensuing business and political ramifications that followed.