Tuesday, December 01, 2015

Federal Reserve Rate Rise Waiting Game

The anticipation over the Federal Reserve's likely target rate increase is approaching fever pitch, at least for a few thousand economists, bond traders, and analysts who are otherwise surgically attached to capital markets information systems. We can amuse ourselves with what-ifs while awaiting the Fed's formal announcement.

What if the Fed raises rates by only a notional amount, like 25bps? Money market fund managers will probably breathe a sigh of relief that they won't face extraordinarily large redemptions. We cannot say the same for fixed-income fund managers, especially those with actively managed portfolios skewed towards the long end of the yield curve.

What if the Fed raises rates more than the notional amount, like anything from 25bps to 100bps? Money market funds would scramble to meet redemptions if they own anything other than overnight paper. Some of the funds would have to lean on the Fed's emergency tools, making all of the dry runs up until now worthwhile. The US equity markets would likely suffer a severe drop as companies with the weakest balance sheets immediately face higher overnight borrowing costs.

What if the Fed leaves rates unchanged? Bond fund managers breathe a sigh of relief for another quarter and the US stock market gets a little bump. The market bump continues into January if Christmas sales are better than expected. The large investors moving markets, particularly hedge funds, will tend to ignore whether the holiday sales are better or worse than last year's numbers. They only notice the headlines.

The first scenario for a 25bps increase is the most likely one, but doing nothing is always an option. A larger rate increase is probably not an option given its consequences. The Fed needs to test its new emergency levers under real world conditions before it puts the economy on a path to a more normal yield curve. The end of the Fed's emergency lending policy for SIFIs changes one such lever significantly. Testing with minimal stress is always best, but the test must come at some point.