What Asset Categories Gain From The Fed Decision?

The much anticipated Fed decision following the September 16-17 meeting of FOMC resulted in a 9-1 vote decision against hiking rates. The doves won out in this round, and the lone dissenting hawk seeking a 0.25% rate hike will have to wait until the next round. Tremendous anxiety dogged the markets leading up to the September 17 decision by Janet Yellen, Stanley Fischer and the FOMC. While percentages varied between economic analysts and traders, there was a 25% – 30% perception that rates would be increased in September, with economists more evenly split at 50-50. Now that the decision has been made to retain rates at the 0% – 0.25% range how does this impact on asset categories?

Currency traders have been embroiled in a frenzy of buying and selling with emerging market currencies seeing the most activity of all. Typically what happens in the run-up to a rate hike is that the emerging market currencies get dumped en masse. For days before the decision was made, currency traders were buying up emerging market currencies at a furious pace. The South African Rand, the Brazilian real, the Russian ruble, the Venezuelan bolivar, and scores of other EM currencies gained ground. After the decision, they continued to rally but soon gave up all gains. It is particularly curious why this happened.

Currency markets like equities markets are driven by sentiment. While market anxiety was quelled after the Fed decision, speculators are fully aware of what Yellen said in comments following the announcement. She did not rule out the likelihood of a rate hike in October, November or December. This means that short-term market anxiety may have abated, but the likelihood of a rate hike remains. The immediate impact of a rate hike on the USD is clear: the greenback strengthens and emerging market currencies plummet. Therefore what we have seen recently is a run on the dollar with put options left, right and centre. But overall, the greenback remains the currency of choice moving forward over the long-term.

The fundamentals of the US economy are sound. Unemployment is at historical lows at 5.1%, the PMI manufacturing numbers reflect an expansionary economy, consumer sentiment is up and GDP is growing albeit at reduced rate. It is important to point out the reasons why a rate hike was not effected at this time. Both Yellen and vice-chair Stanley Fischer are targeting an inflation rate of 2%. The inflation rate reflects increasing prices in the US economy, but owing to the weakness in energy prices (crude oil and natural gas) prices in the US have not been rising. With crude oil trading between $44 and $50 per barrel (WTI and Brent crude) it is difficult for global prices to show any inflationary effect. Currently, US inflation is hovering around 1.2%, and this level is regarded as too weak to warrant a rate hike just yet. If the Fed decides to hike rates with low inflation, it could have the opposite effect and cause a contraction in economic performance.

What effect does a rate hike have on the US economy?

At its most basic level, a rate hike increases the cost of borrowed money. In other words people who have home loans, auto loans, credit card debt, or other debt obligations have to pay more for money that they have borrowed. This has the effect of reducing the personal disposable incomes of everyday consumers. Therefore the effect is contractionary and that is why it is called monetary tightening. At this critical juncture in the US economy, tightening is the last thing that regulators want. The flip-side of the coin is that increased interest rates (even 0.25%) will attract foreign direct investment in huge numbers. With interest rates around the world at historically low levels, the appeal of investing money that actually earns a yield in a safe and secure first world economy like that of the US is without equal. European interest rates are at multi-year lows and no yield stands to be gained by investing money in government bonds and interest-bearing accounts.

Big winners of the Fed decision are clear: utilities and real estate. Now that people don't have to worry about paying more, there is plenty of bullish sentiment around these sectors. This is good for the US economy. Call options on these sectors are abundant, but they should be tempered because they are short-term realities. Things get really interesting when we consider equities markets and gold. One would expect that Wall Street would rally on the back of the Fed decision. In fact, the S&P 500 index, the Dow Jones industrial average and the NASDAQ all ended sharply lower, as did European bourses. The effect of interest-rate hikes on equities is clear: rate hikes increase the cost of borrowed capital, thereby decreasing company profits, EPS and dividends to shareholders. This has a contractionary effect on company stocks and indices.

So Why Did Equities Markets Plunge?

The most rudimentary explanation for this is China weakness. US policymakers typically do not take global economic conditions into account when making a domestic decision vis-a-vis interest rates. However such was the anxiety around the equities meltdown in China and its domino effect on global markets that the Fed decided not to hike rates at this time. This shows that weakness in China is a lot more serious than we had otherwise given it credit for. One thing that markets despise more than anything else is uncertainty. The anxiety about China is real and investors and traders are unwilling to go long on equities, knowing that China weakness is largely responsible for the Fed decision. And besides, Janet Yellen did not rule out the possibility of increasing interest rates in October, November or December of 2015.

Big Winner: Gold Regains its Lustre

So what we are seeing now are myriad trading opportunities across the board. Gold is clearly one of the biggest winners in the saga. Gold soars when the USD plunges. We are seeing the US dollar index trading at low levels, and this is good for precious metals like gold, silver and platinum. The price of gold has spiked, and gold futures are plenty popular among traders now. Gold is the asset of choice when uncertainty pervades the equities markets. The price of gold hit an intraday high of $1,133 on Wall Street following the decision, and traders are going long on the precious metal in the short-term. Gold is currently trading at $1,138.93 an ounce (September 20, 2015). Watch this space – the roller coaster ride is just getting started!