This is the question that is dominating fundamental analysis of today’s Forex market, and has been for quite a while. The reason is that the U.S. Dollar is the largest currency by both total volume and by trading volume, and as such it is usually the key driver of directional moves in the Forex market. The most durable trends tend to occur when the U.S. Dollar is especially strong or weak.
It is a very important question and the answer will be determined at least partially by several items of data that have not yet been generated. However, I believe that the Federal Reserve will not raise its base rate in September.
Why is the Fed Rate Hike Question So Important?
While technical analysts look to historical prices in order to make an educated guess as to future price movements, fundamental analysts look to economic data from national economies. A very key piece of data is the base rate, i.e. the rate of interest set by a country’s central bank at which it will lend. Typically, a country that raises its base rate will see the relative value of its currency rise, as it becomes more attractive to investors. Conversely, a cut in the base rate will usually see the opposite occur. When surprise rate cuts or hikes are announced, the value of the currency affected tends to move quickly and dramatically.
There are two additional reasons why the Federal Reserve’s actions in September are subject to so much speculation.
Firstly, the U.S. has been generally seen by the market as the world’s strongest economy for at least the last couple of years. Fundamental analysts would argue that this was the reason for the strong rise we have seen in the USD during this period of time. For quite some time, there have only been two G7 countries that have been seen as serious candidates to raise their base rates in the near future: the U.S.A. and the U.K. These two currencies have been relatively strong, and after a recent tailing off in that bullish trend, the U.S. Dollar would be well-positioned to rise strongly if the Federal Reserve does raise the base rate.
Secondly, for several years now the world has been living in an era of “cheap money”, with many countries slashing their rates to near zero or even negative rates. With many central banks having dramatically eased liquidity, many economists would argue that several currencies, most notably the two largest by volume (The U.S. Dollar and the Euro), have been undergoing programs of effective devaluation.
The U.S. has not raised its base rate for an astonishing eight years, ever since the great financial crisis of 2007/08 hit. Even though a possible rate hike from 0.25% to 0.50% is a relatively small thing, its novelty gives it immense psychological importance.
A First Hike Usually Signals an Overheating Economy
Another important aspect to consider is the “rate cycle”. Central banks usually gradually raise or lower rates over a long period of time, and change direction when they determine the economy is either “overheating”, when they will raise rates to try to dampen demand, or coming close to “deflating”, at which time a lowering of rates will hopefully increase demand. Of course, this is an oversimplification, but it is the basic gist of the cycle.
Therefore a first rate hike in eight years will be a statement by the Federal Reserve that they see the U.S. economy as robust and finally back to “normal” after eight years. I believe they want to raise the rate, for this and other reasons. It has to be asked, though, whether such a hike is still too risky. It might lead to another recession and possibly trigger a stock market sell-off – the S&P500 Index is not far off making its first “bear cross” for over three years. Is the U.S. economy truly strong and fully recovered?
The Fundamental Strength of the U.S. Economy
Let’s take a look at the data:
The Unemployment Rate is at 5.5%, which is generally considered to be quite close to “full employment” these days. This supports a hike, but critics point to the fact that the Labor Force Participation rate is currently at only 62.6%, its lowest rate for 28 years.
The Inflation Rate is only 0.1%. Inflation has all but disappeared, and therefore it could be argued a rate hike at this moment risks creating deflation. An inflation rate of 0.1% can hardly be said to indicate an overheating economy!
Stock markets are at all-time highs and the bull market has lasted at least three years, or possibly longer depending upon its definition. This would tend to support a hike.
Gross Domestic Product is increasing at an annualized rate of 2.3%, which is relatively healthy. However the previous quarter showed an increase of only 0.6%.
Non-Farm Payrolls has been quite positive for several years, but has been on a downward trend since October 2014, despite recovering from its lows in recent months.
Earnings are broadly stagnant, which is not supportive of a hike.
Crucial Data to Watch
I believe that the Federal Reserve strongly desires to hike the rate by 0.25% at its September meeting, mainly due to a strange reason: if they do not get rates up before the economy gets into trouble again, what stimulus do they have left in reserve if such an event should occur? There has already been a massive program of quantitative easing, or massive printing of fiat debt currency if you prefer that term instead.
The Fed knows that they must be very careful, and that at least two crucial pieces of data that will be issued before their decision will have to be supportive. Otherwise I believe they will not dare raise the base rate. The key data will be Annualized GDP and the Non-Farm Payrolls numbers. These numbers will have to at least broadly meet the market’s expectations in order for the Fed to make a hike.
Another issue worth mentioning is that the recent appreciation of the U.S. Dollar is widely seen as choking potential growth in the U.S. Economy by making U.S. exports more expensive. Hence the Fed has to be careful not to fuel that rise in the dollar, and there is every sign, given the weakness of most of the other major global currencies and commodities, that a rate hike would see the U.S. Dollar take off again.
I contend that if the next GDP and Non-Farm Payrolls numbers are notably poor, there will certainly not be a rate hike in September.
