The Fed December rate decision is just a week away and the markets believe the Fed would finally raise rates after having telegraphed the same since mid 2014.
The two things debated now are – whether the liftoff would be a conventional 25 bps move or less than 25 bps and if the equity markets would correct following the liftoff. The other widely discussed thing – whether the USD will be “sold on fact†is discussed here.
The Fed’s response to the 2008 crisis was unprecedented (QE, low rates), despite which the economy’s positive response to the unprecedented easing cycle has been marginal. Consequently, the policy tightening could be at a new normal rate of less than 25bps moves; a 12.5bps or 10bps hikes.
In 1994-95 tightening cycle, the stock markets dipped in the first half of 1993 and recovered but remained range bound. The 1999-2000 tightening cycle was followed by a Dot com bubble burst. The 2004-2006 tightening cycle saw the DJIA remain resilient, but eventually cracked on housing crash.
A 25bps rate hikes over the next year risks a sharper correction in the stocks since the market is extremely overbought near record highs. Overall, the likelihood of a controlled (slow and steady) correction is high this time as the Fed is likely to move rates at a slow speed of less than 25bps hikes over the next year.
Moreover, Fed would not hike rates at a speed, which could derail stock markets as it would risk an asset price crash and another recession. The slower the pace of the Fed tightens, the lesser the risk of a sharp fall in stocks.
The two things debated now are – whether the liftoff would be a conventional 25 bps move or less than 25 bps and if the equity markets would correct following the liftoff. The other widely discussed thing – whether the USD will be “sold on fact†is discussed here.
| Tightening cycle | Rate hike | DJIA |
| Feb 1994 - Feb 1995 | From 3% to 6% | Rangebound: 3550-3980 |
| June 1999 - May 2000 | From 4.75% to 6.6% | Sideways action for almost a year, followed by a drop (Dot com bubble) |
| June 2004 - June 2006 | From 1% to 4.25% | Rose almost throughout the tightening cycle |
Some observations
- The tightening included conventional 25 basis point moves
- Tightening begun from well above the zero lower bound
- The preceding loosening cycle did not include unconventional policy moves
- The sharp increases in the overnight lending rate in 1999 required little more than 8 months before the Dow Jones Industrial Average descended 31.5%
What is different today
- Rates have never been this low and have never stayed this low for so long
- We have had unconventional policies during easing cycles (three rounds of QE)
- Stock markets are at record highs; a 6-1/2 year old bull market
- 10-year treasury yield is at 2%-2.2% (In 2004 it was at 4%).
The Fed’s response to the 2008 crisis was unprecedented (QE, low rates), despite which the economy’s positive response to the unprecedented easing cycle has been marginal. Consequently, the policy tightening could be at a new normal rate of less than 25bps moves; a 12.5bps or 10bps hikes.
In 1994-95 tightening cycle, the stock markets dipped in the first half of 1993 and recovered but remained range bound. The 1999-2000 tightening cycle was followed by a Dot com bubble burst. The 2004-2006 tightening cycle saw the DJIA remain resilient, but eventually cracked on housing crash.
A 25bps rate hikes over the next year risks a sharper correction in the stocks since the market is extremely overbought near record highs. Overall, the likelihood of a controlled (slow and steady) correction is high this time as the Fed is likely to move rates at a slow speed of less than 25bps hikes over the next year.
Moreover, Fed would not hike rates at a speed, which could derail stock markets as it would risk an asset price crash and another recession. The slower the pace of the Fed tightens, the lesser the risk of a sharp fall in stocks.
Impact on EUR/USD
- In case the Fed begins tightening at a pace of 25bps, the initial reaction could be a drop in the EUR/USD, but a sharp fall in stocks could offer support to the EUR/USD pair.
- IF the Fed begins tightening at a pace of less than 25bps hikes, the EUR/USD could convincingly rise above the trend line resistance at 1.10 move back to 1.14 levels in the next couple of months.
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