How The Next FOMC Meeting Will Affect Your Trading
The US Federal Reserve’s September meeting didn’t spring many surprises. As expected, short-term interest rates remained unchanged. For the time being, they will continue to stay in the 1% to 1.25% range.
Fed Chair Janet Yellen announced that beginning in October, the process of normalising the central bank’s balance sheet would begin. In the years since the global financial crisis of 2007-08, the Federal Reserve had more than quadrupled the size of its balance sheet to US$4.5 trillion by large purchases of mortgage-backed securities and Treasuries.
Although the announcement that the balance sheet size would be reduced was anticipated, it is important to note that this step signals a major shift in policy. The quantitative easing that led to the ballooning of the balance sheet was initiated in November 2008 to counter the effects of the turmoil in the financial markets. The intention was to increase the money supply and to keep interest rates low.
Quantitative easing was discontinued in 2014 as the economy was thought to have recovered sufficiently. Now the Fed is initiating the next stage of its monetary policy. Janet Yellen says, “We think the economy is performing well…. We are working down our balance sheet because we feel stimulus is no longer needed.”
The process will be slow and will begin with a reduction of US$10 billion a month and gradually rise over the next year to US$50 billion a month.
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How a shrinking Fed balance sheet could impact the markets
An exercise that involves taking tens of billions of dollars out of the system month after month could have a significant effect on the world’s financial markets. The Federal Reserve holds trillions of dollars of Treasuries and bonds that have various maturity dates. Till now, it has been reinvesting the proceeds on maturity.
But with the implementation of the revised policy, the bonds will be allowed to run off naturally when they mature. The expectation is that as this “tapering” will be done gradually, the consequences on the markets will be minimal.
It is important to remember that the US stock market has provided excellent returns over the last few years. This performance is not proportionate to the rate of economic growth. The accepted view is that share prices have climbed to record highs at least partly because of the excess liquidity in the market. Funds have been easily available at low rates.
But this may be about to change now. A reversal in the monetary policy could have a large impact on share valuations, exchange rates, and even gold prices.
Gary Christie, Senior Technical Analyst on the US equity and commodity research desk at CME Group will be discussing the effects of the changes in monetary policy by the Federal Reserve at a webinar on Oct 25. Learn more about it here.
How will gold prices react?
Stock valuations and gold prices often share an inverse relationship. When share prices are high, investors stay away from the precious metal. Currently, the equity markets are at record levels.
Research conducted by Nobel laureate Robert Shiller reveals that the C.A.P.E. ratio, a sophisticated version of the more commonly used PE ratio, is currently at 30. This is almost double the average of the16.8 that it has been since 1881. There have been only two other instances when this earnings ratio has been so high.
In 1929, the ratio was 33 and in the period from 1997 to 2002, it touched 44. Both these peaks were followed by a crash in the stock market.
What does this tell us? The stock markets are highly overvalued and could be poised for a major correction. The trigger for this could very well be the draining of liquidity from the markets as a result of the Fed’s policies.
If the stock market crashes, it is very likely that gold prices will see a rapid upward trend. Investors can take advantage of this by trading gold futures.
Investing in physical gold can be costly and cumbersome. But gold futures offer a simple way to profit from price movements in the precious metal. You will be entering into a standardised contract that will be cleared through a centralised exchange. There will be no need to handle physical gold or arrange for its storage and insurance.
Learn new strategies for gold futures trading in the current market, with CME Group. Sign up for the “FOMC Meeting – How It Impacts Your Trading” webinar with Gary Christie on Oct 25.
Impact on currency markets
A hike in rates by the Federal Open Market Committee (FOMC) usually results in the US dollar appreciating. Starting in mid-2014, dollar values appreciated by 20% in a nine-month period.
A currency that commands a high interest rate tends to appreciate relative to a low-interest-rate-currency, because funds will flow into the currency that pays a greater rate of interest. As the Fed raises interest rates, the dollar can be expected to appreciate.
The FOMC has already hiked interest rates twice in 2017. Although a rate hike was not made at the September 19-20 meeting, a third hike is expected by the end of this year.
The next meeting of the FOMC is scheduled on October 31 – November 1. According to the CME Group’s projections there is a very small probability of a rate hike at this meeting. The CME FedWatch Tool estimates that there is only a 2% chance of a rate hike on October 31 – November 1. But the subsequent meeting on December 12-13 will probably see a rate hike of 0.25%.
Analysts also expect that there will be three hikes in 2018, two in 2019, and one in 2020.
If these rate hikes take place, they could lead to continued appreciation of the US dollar.
Investors who are active in the forex market can use currency futures to capitalise on the expected change in the value of the dollar or other major currencies.
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Tapering may have adverse consequences
The Fed’s decision to reduce the size of its balance sheet could impact global financial markets.
Balance sheet normalisation has been attempted six times in the past in 1921-1922, 1928-1930, 1937, 1941, 1948-1950, and 2000. Five of these periods ended in a recession. The research has also discovered that 10 of the last 13 tightening cycles when the Fed raised interest rates, ended in recession.
This time around, the Fed is going about the exercise of rate increases and tapering in an extremely measured and gradual manner. At present, there are no indications that the Fed’s policy is having any adverse effects on the economy. But investors would do well to remember the manner in which the markets have behaved in earlier years and take pre-emptive measures to protect their portfolios.
For more details on trading gold futures and forex futures in this environment, sign up for the “FOMC Meeting – How It Impacts Your Trading” webinar now.