Federal Reserve on verge of historic interest rate hike

Enrique Díaz-Álvarez10/Δεκ/2015Currency Updates

The US central bank has maintained what amounts to an emergency setting of monetary policy ever since former Chairman Ben Bernanke announced that the Federal Reserve would be cutting its benchmark interest rate to effectively zero during the height of the financial crisis in December 2008.

However, after current Chair Janet Yellen removed the need to be “patient” from the Fed’s monetary policy statement in March this year, currency traders have been eagerly anticipating the first interest rate hike in the US since 2006.

Key date: December 16

All attention in the currency markets is now firmly focused on the Fed’s next monetary policy meeting at 7pm UK time on 16 December, with the US central bank widely expected to announce an increase in its benchmark interest rate for the first time in nine years.

At the previous Federal Open Market Committee (FOMC) meeting in October the Federal Reserve left the door firmly open to a rate increase this month. While policymakers claimed they would continue to monitor economic and financial developments abroad, they removed the line from the previous statement that suggested global developments could restrain economic growth.

Data dependent hike

Critically, the Fed also explicitly mentioned the possibility of a December hike by saying: “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress – both realised and expected – toward its objectives of maximum employment and 2 percent inflation.” It is clear to us that these conditions have been met in the past month.

Economic data since the last Federal Reserve meeting, particularly from the labour market, has been sufficiently positive to warrant a hike in our view. The two most recent nonfarm payrolls figures both exceeded expectations. The October number soared to a revised 298,000, its highest level all year (Figure 1), while another solid performance in November took the three month average to a healthy 220,000. Unemployment is also at a seven year low at 5.0%, while average earnings growth, while still modest, is around its highest levels since late-2009.

Figure 1: US Nonfarm Payrolls (2010 – 2015)
Figure 1 US Nonfarm Payrolls (2010 2015)

Source: Thomson Reuters Datastream Date: 07/12/2015

Moreover, economic growth remains robust, despite moderating somewhat to 2.2% on an annualised basis in the third quarter. Headline inflation remains low, dragged down by energy prices, but the level of core price growth is nearing the central bank’s target, having increased to 1.9% in October (Figure 2), while concerns surrounding global stock markets appear to have subsided.

Figure 2: US Inflation Rate (2012 – 2015)
Figure 2 US Inflation Rate (2012 2015)

Source: Thomson Reuters Datastream Date: 07/12/2015

Hawkish commentary

Commentary from policymakers since the last meeting has been similarly hawkish. Speaking in front of Congress in Capitol Hill in the first week of December, Janet Yellen suggested that the US economy should continue to experience steady growth and was reaching a point where it could handle an interest rate hike.

As expectations for higher rates firmed, the US Dollar surged to its strongest position in over twelve years in December (Figure 3) against its major peers, only to be driven lower by an underwhelming quantitative easing announcement by the European Central Bank.

Figure 3: US Dollar Index (January ‘15 – December ‘15)
Figure 3 US Dollar Index (January 15 December 15)

Source: Thomson Reuters Datastream Date: 04/12/2015

Our Expectations

Given recent hawkish comments from Federal Reserve policymakers, and the impressive economic data we’ve seen in the US of late, we see the Federal Reserve as all but certain to begin its monetary tightening cycle at the next FOMC meeting on 16 December.

While there will undoubtedly be dissenters, possibly even as many as three, we expect a rate increase by 0.25%, with the Fed to reiterate that further rate hikes will be both gradual and data-dependent. The market is now undoubtedly in agreement, with pricing for a December rate increase now close to 80%, the highest level it’s been all year, though we think this should be higher still.

Gradually increasing interest rates in the US should cause the US Dollar to strengthen against almost every global currency. This appreciation should be most severe against the Euro, given the recent expansion of the European Central Bank’s easing measures, with a more gradual strengthening of the Dollar against Sterling.


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Written by Enrique Díaz-Álvarez

Chief Risk Officer at Ebury. Committed to mitigating FX risk through tailored strategies, detailed market insight, and FXFC forecasting for Bloomberg.