The FOMC Trade: New Year, New Head, New Hike.

2017-12-06 | Simpler Trading Team

A Senate panel has approved Jerome Powell to be the next Federal Reserve chair. The panel’s green light clears the way for Powell to receive full Senate approval and replace Janet Yellen when her term ends in February.

Powell, who has served on the Fed since 2012, promises to follow the path set by Yellen and continue raising interest rates.

What does that mean, exactly?

One of the Federal Reserve’s primary tasks is monitoring the federal funds rate, which is a short-term interest rate applied to financial institutions that loan funds to other financial institutions (generally overnight).

This rate affects monetary and financial institutions, which in turn affects employment, growth, and inflation.

Basically, the higher the federal fund rate, the more expensive it is to borrow money. The more a bank pays for its money, the more the bank’s customers have to pay for mortgages, car notes, credit cards, and loans.

Why does the Fed raise rates?

Simply put, the Federal Reserve raises interest rates to combat inflation. With the economy surging under President Trump and getting a big boost from tax reform, spending should increase significantly, leading to inflation.

Inflation is just an increase in the cost of goods and services over time. It’s the downside of a strong economy. Supply and demand dictates that as spending increases, so do prices. Interest rates are intended to reduce spending, thereby curbing inflation. If inflation rises too much, it weakens the dollar and can drastically reduce purchasing power.

But higher interest rates do more than slow inflation — they also give the economy its strongest weapon in combating a recession.

Since World War II, the country has experienced a recession about once every six years. This means that another recession is inevitable. Interest rates are used to combat recessions by lowering rates to facilitate not only spending, but more favorable conditions for borrowing. This encourages spending and economic growth.

The average federal interest rate since World War II has been around 5 percent, with the highest rate since then being almost 20 percent.

Today, the federal interest rate is 1.25 percent.

This means the Fed has very little room to cut interest rates to encourage borrowing and spending should another recession hit the United States.. It also means the Fed has a lot of room to raise rates, which they are expected to do December 13th.

Historically, as interest rates have gone up, trading has mirrored spending and gone down. When interest rates are on the rise, consumers aren’t the only ones cutting back on spending. Businesses also minimize costs. Banks restrict lending. Companies hold off on acquisitions and investments. These moves drag down the market.

This doesn’t mean a market crash is imminent.

The stock market continues to climb despite expectations that rates will be near 1.50% by year’s end.

We can see a major pullback and still be in an uptrend. But traders should keep an eye on the federal funds futures contract. This contract is how traders and investors speculate on the future Fed Funds Rate. Looking at the trend in the March and June 2018 contracts, the trajectory is clear: More hikes.

In the past, Yellen has hinted at multiple rate hikes in 2017, 2018, and 2019 after nearly a decade without a single hike. That’s a big part of why the economy has been so strong. But with 2017 seeing multiple hikes as promised, 2018 and 2019 should see the same if Powell sticks to his commitment. Powell has not dissented with his predecessors, Yellen and Bernanke. This offers insight into the kind of FOMC Chair he may be.

In the end, rate hikes may be frustrating for consumers, but they benefit the U.S. dollar, stock market, and economy as a whole. With half a dozen rate hikes over the next 2 years, we can expect things to gradually slow down. However, one angle that much of the market may have wrong is the effect on bonds from the Fed balance sheet unwinding, as well as whether the U.S. dollar will rally.

With the European Central Bank reducing asset purchases it can only beg one question: When will the ECB signal they are beginning to raise rates, too? This will be a drag on the U.S. dollar.

The trades will be in the euro, dollar, bonds, and financial. 2018 will be an exciting time for traders watching central bank rates globally.

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