An "It's Time" Rate Hike
Let's say the FOMC raises its benchmark Fed Funds rate slightly, saying "it's time" and/or that the committee needs to have ammunition in place (i.e. the ability to lower rates again) if the need arises in the near future. (The latter reasoning is the equivalent of putting on a jacket when it's hot outside so you have a layer you can take off if you get too warm.)
Half of the investment community is expecting this already, and I don't think the other half would really be that surprised. Still, the market reaction would likely be negative -- at least at first.
No Hike Now, but Maybe Later
In this case, the FOMC wouldn't tighten, citing global weakness and currency concerns on international trade. But the Fed would leave a December hike on the table should conditions permit one.
The other half of the investing community is expecting this. So, the market reaction would likely be positive at first.
A Communique Citing Global Worries
An option that doesn't seem to be getting much consideration would be the FOMC deciding to either hike or not (take your pick), but then expressing an acute awareness of exactly what's been plaguing equity and fixed-income markets:
- The strong U.S. dollar, which has caused weak commodity prices, exacerbating the strain on emerging-market economies and currencies. Another effect has been stress on big-cap U.S. companies that rely on sales in foreign countries (whose currencies are weakening in relative terms). And then there's the impact on domestic employment. Weaker foreign currencies in relative terms incentivize U.S. companies to outsource as much work as possible.
- High-grade and high-yield bonds. As higher short-term rates provide slightly more incentive to reduce risk on the fixed-income side, I'm not sure how much money would flow out of riskier, higher-yielding bonds and into the newly risk-free rate of, say, 0.25% to 0.50%. Personally, my guess is none. Keep in mind that a rate hike makes dollar-denominated debt even more attractive to foreign companies and governments looking for a place to park short-term cash. This would almost certainly keep a lid on how high our rates really get.
- Uncertainty (the biggest factor of all). Uncertainty doesn't just apply to what the Fed Funds rate will be, but also to what the FOMC is seeing and thinking. As food for thought, what kind of market reaction do you think we would see from a Fed statement like this: "We are aware of all the above and would like to assure investors that we have the ability and willingness to reverse course if need be and/or to stimulate the economy in other ways than merely the Zero Interest Rate Policy (ZIRP). We also believe weakness in certain segments (i.e. energy) are transitory and unrelated to ZIRP, while the labor market's underlying fundamentals continue to improve across the board. Taking rates off of zero won't hinder this pattern or our 2% inflation goal. Rather, it will more likely contribute to their effective continuation."
The Bottom Line
Is the concern really whether the Fed raises overnight rates from a 0% to 0.25% range to a 0.25% to 0.5% one? Or is the concern that the Fed is somehow unaware of the risks associated with such a move?
Let's be honest -- how likely is it that Janet Yellen and the rest of the Fed governors are just completely unaware of what could happen to the dollar, high-yield bonds, international markets, home affordability and domestic job growth?
I'm not particularly concerned with what the Fed does with rates on Thursday, but solely on on the language associated with its announcement. I think that's where the market's real reaction should -- and will -- come from.
- What happens when the Fed hikes interest rates?
- Why it's so hard for the Fed to raise interest rates.
- The good, bad and ugly outcomes on higher interest rates.
- Everything you wanted to know about the coming Fed rate increase.
- Three things the Fed may do at its meeting this month.
- What the Fed is watching in the economy before it makes a decision.
- Why the Fed should be raising rates now.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.