The Fed Decision: Analyzing the Reaction

Just in case you are living under a rock and missed it, on Wednesday the new Fed chair, Janet Yellen, gave her first press conference following a rate decision. Fed release day always brings back memories for me. There was a unique atmosphere in a dealing room while awaiting the rate decision. Usually trading stopped and orders were withdrawn a minute or so before the scheduled release, even if nothing momentous was expected. All eyes went to the screens, waiting for the news. There was a sense of anticipation and excitement, but after a few years I realized that the strongest emotion was fear.

We weren't afraid that the market would move against us; we rarely ran anything but the smallest position into the Fed's rate decision. Rather it was a fear that something momentous or unexpected would happen and we would be left out. For those that are paid to trade, failing to react to news is a greater sin than getting it wrong. Little wonder, then, that the initial reaction to any news was usually an overreaction.

In many ways, things are different now. Computers and algorithmic trading programs are the ones looking to react immediately to any decision, but initial overreaction is still common. On Tuesday, when those computers and the traders heard talk of rate rises in the future, they reacted. The stock market dropped, bond yields jumped and the US Dollar gained against every major currency. Commodity prices fell in the face of Dollar strength.

The question that we, as humble retail traders and investors must ask is, how much of that is just a knee-jerk overreaction, and how much does it give us a direction for the coming weeks and months? To answer that question, we should look at each market separately.

Stocks: The move down in stocks was the best example of what I am talking about. It strikes me as an overreaction to those scary words about reductions in asset purchases and rate rises. If we look at what was actually said, however, there is no real reason why the stock market should be trading lower. A collection of the best informed and smartest economists in America (the Federal Reserve Board), after carefully considering the evidence, has decided that the US economy may, at some point in the not too distant future, be able to survive baby steps back to normality. That's it; not a precipitous jump in rates, not an immediate end to QE, just a belief that the end to Central Bank support of the market and abnormally low rates may be in sight.

If they are right and economic recovery continues, then the market will reflect that before too long. If they are wrong, then they have reserved the right to continue with ultra-low rates. Either way, all other things being equal, a drop in equities looks unwarranted and is unlikely to be a sustained move.

Bonds: The story in the bond market is a little different. Bond prices are driven by yield. If prevailing interest rates are, say 5%, then a bond with a 10% coupon will trade at above face value to bring the yield down and reflect the current rates. If rates were to rise to 10% then that bond would drop back to face value. Whatever the state of the economy in a year's time, if rates go up then bond prices will fall. The bond market is, like the stock market, a forward discounting mechanism, so higher yields and lower prices at any suggestion of higher rates in the future is a natural and sustainable move.

Currency: What many people don't realize is that the foreign exchange market is also driven by yield to some extent. By definition, when you trade you leave yourself short of one currency and long of another. If a bank or financial institution sells Euros against US dollars (EUR/USD) for example, and doesn't close the position on the same day, their Euro account will be in deficit (overdrawn) while their Dollar account will have a surplus. The difference between what you must pay in interest to borrow money to cover that overdraft and what you receive for loaning out your surplus is the "cost of carry". When trading in tens of millions or more, even slight changes in the interest rate differential can have a significant effect.

With the prospect of higher rates on the horizon, US Dollars become relatively more attractive. They are more rewarding to hold and more expensive to borrow, and will stay that way for a while. Nothing ever moves in a straight line in Forex, but as the Yen has shown over the last few years, once fundamentals change and a long term trend forms, it can continue for a while. Dollar strength will not be as strong as Yen weakness has been over that time, but I expect it to continue. That leads us to…

Commodities: Commodities are priced in US dollars. If the Dollar does go on a sustained upward run, then commodity prices, including oil and natural gas, will come under pressure. Each dollar is worth more in relative terms, meaning each barrel of oil, for example, is worth relatively less. If I am right about continued Dollar strength, then the move down in oil, gold and other commodities on Wednesday looks like it may a harbinger of things to come.

Of course, all of this could be derailed by other factors. The situation in the Ukraine could worsen, Chinese growth could continue to slow, or North Korea could do something crazy. Better than expected global growth could create more demand for commodities and cause other countries to consider raising rates…any number of things could happen, but, in the absence of any other shocks, I expect to see stocks recover, the dollar to gain strength and bonds and commodities to remain lower.