Download what the fed liftoff means for the us dollar and stocks

WHAT THE FED LIFTOFF
MEANS FOR THE US DOLLAR
AND STOCKS
Matt Weller, CMT, Senior Market Analyst
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an o er or solicitation with respect
to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This
report has been prepared without regard to the speci c investment objectives, nancial situation and needs of any particular recipient. Any references
to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are
likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its
accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any
person upon any such information or opinions.
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Quick quiz:
What’s different about 2016 versus every year since 2007?
Answer: This year will mark the first time in nearly a decade that the US Federal Reserve will not be actively
stimulating the US economy.
Put another way, the last time the Federal Reserve raised interest rates, everyday amenities that we take for granted such as the iPhone, Twitter,
and Netflix had not yet been invented; George W. Bush and Tony Blair were the heads of the US and UK governments, respectively; and Lehman
Brothers, Bear Stearns, and Washington Mutual were major world banks.
Given that it’s been so long since the Federal Reserve last raised interest rates, we wanted to examine the historical performance of the US dollar
and US equities when the Fed embarked on rising interest rate cycles in the past. As always, past performance is no guarantee of future results and
every time period is unique, but a familiarity with historical tendencies can only be beneficial for traders as we navigate the “new normal” of 2016.
Before we get too deep into it though, the first takeaway for traders is that periods when the Fed is actively raising interest rates tend to be
relatively short. In the past thirty-five years, the Fed has embarked on six distinct rate hike cycles with the typical cycle lasting only about one or
two years before the central bank was forced to cut interest rates again. Whether the brevity of past tightening cycles is a result of the Fed raising
rates too quickly or starting from behind the ball in the first place, traders preparing for a prolonged, secular shift toward a consistently hawkish
central bank over the next half-decade or so may be disappointed.
Don’t forget that you can now follow Forex.com’s
research team on Twitter: twitter.com/FOREXcom
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What about the Greenback?
The conventional theory is that rising interest rates in the US, especially vs. the rest of the world, should lead to strength in the US dollar. As the
modern baseball-player-turned-philosopher Yogi Berra once noted, “In theory there is no difference between theory and practice. In practice
there is.”
The chart below shows the performance of the Federal Reserve’s “Major Currency Trade-Weighted US Dollar Index” in the 90 days before and 180
days after the start of a Fed rate hike cycle. This mouthful of an indicator is slightly different than the more widely followed dollar index (DXY), but
still accurately depicts the historical performance of the buck:
Source: FRED, FOREX.com
As the chart above shows, the dollar’s performance in the wake of past rate hike cycles has varied dramatically. Following the 1983 and 1988
interest rate increases, the dollar went on to gain another 10% in less than three months after the Fed raised interest rates, whereas the greenback
fell by over 5% in three other occasions (1986, 1994, and 2004) and was essentially unchanged six months after the 1999 rate hike.
On average though, the US dollar has tended to lose over 3% in the first six months following the start of rising interest rates, as the below table
shows:
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Clearly, the reality is more complicated than the simplistic “rates up, dollar up” analysis would suggest.
Gazing into our crystal ball, it seems logical that the Fed’s impact on the dollar will depend on how the central bank performs relative to the
expectations that are already baked into the market. Though the Fed’s latest Summary of Economic Projections (SEP) dot chart suggests that the
median member anticipates raising interest rates four times in 2016, traders are much more skeptical. In fact, according to the CME’s FedWatch
tool, Fed Funds futures traders have only fully priced in two increases by year-end 2016.
If the US economy continues to improve and the Fed is able to meet its expectation of four rate hikes, the ensuing monetary policy divergence
could push the dollar to new heights against its rivals in 2016.
However, the more likely scenario in our view is that the Fed will only be able to raise interest rates about twice in 2016. As the recent deterioration
in FX-sensitive areas of the US economy (namely the trade balance and manufacturing) shows, the elevated value of the US dollar is already
starting to weigh on economic activity. The last thing the Fed wants to do is choke out economic growth and the nascent price pressures by raising
interest rates too aggressively and therefore may err on the side of caution when it comes to raising interest rates. If this scenario plays out, the
dollar’s reign as king of the FX world could come to an end in 2016.
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How about the US Stock Market?
“Don’t fight the Fed” has been the dominant mantra for equity investors in recent years, with traders actively looking to buy dips in the major US
indices as the Fed continued to goose the financial system. Surely with the Fed now shifting to a tightening cycle, the halcyon days of constantly
rising markets must come to an end?
In this case too, the historical evidence undermines the conventional wisdom:
Source: FOREX.com
As the above chart shows, US equities (as measured by the S&P 500 index) have tended to rise on average both in the 90 days before and 180 days
after the start of a Fed rate hike cycle. Of course, this tendency is exaggerated by the big run-up following the December 1986 hike (purple line),
which led to the “Black Monday” collapse of 1987 a few months later, but the S&P 500 saw a 180-day gain in five of the six previous examples of Fed
“liftoff.”
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Once again, the summary data is displayed in table form below:
Based on this data, it’s difficult to draw any strong conclusions; after all, the US stock market has shown a tendency to rise over most six-month
periods, regardless of what the Fed is doing. That said, this historical record indicates that a Fed rate hike is by no means a death knell for the S&P
500.
Moving forward, the performance of the S&P 500 will also be heavily influenced by Fed policy: if the US central bank is able to raise interest rates
as aggressively as it hopes, US stocks may struggle (both because bonds will become a more attractive investment and because interest costs will
rise for US companies that borrow money). Conversely, a more dovish Fed could support US stocks, though a blockbuster bullish year may still be
difficult given the age of the bull move and fully valued market.
With so much time having passed since the last Federal Reserve rate hike, it’s no surprise that false assumptions about the Fed’s impact on the US
dollar and US stocks have run rampant. As we noted above, past performance does not necessarily indicate future performance, but after reading
this report, you’re now armed with knowledge of the historical tendencies and should be better prepared to take advantage of this historical event.
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Before you trade in volatile markets:
Understand the risk involved
In volatile markets, the price of a certain currency can move very quickly. We encourage you to be vigilant and never trade with funds
you cannot afford to lose. Our team is here to answer your questions; please contact us using these details.
Do your research
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Twitter at @FOREXcom for live updates.
Manage risk
Make sure you monitor your open positions when trading in volatile markets and take advantage of stop-loss and limit orders.
You can also lower the leverage on your account from your trading platform and ensure your account is adequately funded to cover
your open positions.
Foreign Exchange and other leveraged products involve significant risk of loss and are not suitable for all investors. Increasing leverage increases risk. Before
deciding to trade foreign exchange and other leveraged products, you should carefully consider your financial objectives, level of experience and risk
appetite. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient.
Contracts for Difference (CFDs) and spot commodities are not available to US residents.
The charts, data, information, reference to any events or trends and opinions in this report are for general information use or illustrative purposes only and
are not intended as an offer or solicitation to any product offered. There is no guarantee that any event or trend is likely to be repeated or that profits will be
or are likely to be achieved.
FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all these matters.
While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor
does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or
opinions. All information and opinions contained in this report are subject to change without notice.
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