Financial Matters: All eyes on the Federal Reserve

New York (Sept 13)  This coming Thursday, the U.S. Federal Reserve will announce whether or not they will raise interest rates for the first time since June 2006. As recent price volatility in markets suggests, their decision has vast global implications for stocks, bonds, currencies, commodities and the underlying economy. Based on recent comments and speeches by Federal Reserve officials, there is not a consensus among the Federal Reserve Open Market Committee members, the group at the Federal Reserve that sets interest rate policy, on what their decision will be. The decision promises to be a nail-biter with traders and investors globally glued to their screens and monitors.

Interest rates tell us a lot about what both the Federal Reserve and markets think about the current and future states of the economy. While the absolute level of interest rates is indicative of the current state of the economy, the relationship between short-term and longer-term interest rates is indicative of what markets think about the future state of the economy. The Federal Reserve targets short-term interest rates; the market dictates longer-term interest rates.

Note: It could be argued that the Federal Reserve’s quantitative easing policy, which has ended, continues to impact longer-term interest rates.

The relationship between short-term and long-term interest rates, and all points in between, is called the yield curve. The yield curve is a graphical representation of interest rates. On the left side of the x-axis are overnight rates. On the right side of the x-axis is the yield on 30-year U.S. Government Treasury bonds. The yield curve’s natural state is an upward sloping line as there is more inherent risk in lending money for longer time periods; therefore, investors require higher rates of return on longer-term interest rates.

When the economy is strong the slope of the yield curve steepens as inflation, which has a larger impact the longer the interest rate term, is a primary concern. When the economy is weak, the yield curve flattens as inflation risks diminish.

Sometimes the yield curve inverts where short-term rates exceed long-term rates. An inverted, downward sloping yield curve has preceded every recession in U.S. history.

Keep an eye on the slope of the yield curve for a few weeks following the Federal Reserve’s announcement next week. It will say a lot about where the economy is headed.

While the yield curve evolves over time and provides a comprehensive view of the effectiveness of the Federal Reserve’s interest rate policy, other markets could potentially react more quickly to the Federal Reserve’s decision

Perhaps the market that will be most immediately impacted by the Fed’s rate decision is the international market for currencies, which is also the largest market in the world. The value of a nation’s currency relative to other nations’ currencies impacts the price of that nation’s exports. It also impacts the purchasing power of that nation’s consumers.

Relative interest rates between nations is a primary driver of currency values. When interest rates in one nation rise relative to another, yield seeking global investors create demand for that nation’s currency, driving up its value, as they invest in that nation’s higher yielding assets.

Currency values are certainly something investors will be keeping a close eye on should the Federal Reserve raise interest rates on Thursday. If the Federal Reserve does raise short-term interest rates, the value of the dollar will likely rise. In the opinion of the writer, this is likely to expose many hidden global risks and lead to vast global financial rebalancing. As an example, at least part of the recent global market volatility can be attributed to China’s decision to allow its currency to fall in value.

In conclusion, don’t miss the Federal Reserve’s interest rate decision on Thursday. It’s impossible to predict an outcome, but some market somewhere is going to come unglued.

Barry Nielsen has worked in capital markets for over 20 years with a focus on fixed income portfolio and risk management. He has an MBA from George Mason University and holds the Chartered Financial Analyst designation. He currently works for Opportunity Bank of Montana.