It’s nuts if you think about it too hard.
All across the world, things were happening yesterday with the potential to scupper the best-laid plans of investors everywhere.
Russia was still trying to prop up the rouble. The Greeks were having the first round of a presidential election that could end up triggering a general election and fears of a Greek exit all over again. And on a more positive note, Americans can now get hold of Cuban cigars legally once again.
But despite all that, all anyone in the markets was really interested in was the status of two little words.
“Considerable” and “time”…
Moving the market with two little words
“Considerable time.” Why are those two words so important to markets?
Because that’s how long the Federal Reserve expects to keep interest rates low for, after ending quantitative easing (QE). Or at least it was.
But the words were dropped from the notes on the Fed’s latest interest-rate setting meeting. Instead, the Fed will now be “patient” in making a decision on when to start pushing rates up.
So what does that actually mean?
Janet Yellen, the Fed chairwoman, explained it. She said that it’s “unlikely” the Fed will want to raise rates for at least the next couple of meetings. And that some committee members reckon that conditions will be ripe for a rise “by the middle of next year”. But all in all, it just depends on the state of the economy.
What did markets make of it all? The S&P 500 rebounded strongly yesterday, getting back above the 2,000 mark after a rough week. But that had more to do with signs that the oil price and the rouble might be stabilising.
(I’m not convinced on this yet, incidentally – anything that falls this hard and fast has got to pull up at some point, so there’s no guarantee this is the bottom).
Really it was the US dollar’s reaction that showed what investors thought of the Fed’s new stance. It got stronger, suggesting that investors reckon the Fed might be raising rates sooner than it thinks.
The Fed has lots of excuses not to raise rates – but it doesn’t matter
I’m not necessarily convinced by this. The crashing oil price has proved rather unnerving for global markets, and I can’t see the Fed being keen to do anything to scare the horses until the fall-out from this becomes clearer. Falling oil prices also give the Fed the temporary cover it needs to keep rates low – inflation figures won’t look too bad.
But at the same time, I can see the dollar continuing to get stronger regardless. For a start, the economic data is likely to continue improving. Yes, the shale oil and gas boom might tail off. But consumers are already feeling the benefit of plunging oil prices, and given the shape of America’s economy, that’s likely to offset the negatives, in the short-term at least.
The other reason to expect a stronger dollar is a direct result of the plunging oil price. I was reading an interesting piece from Izabella Kaminska on FT Alphaville last night on petrodollars.
High oil prices funnel US dollars to oil-producing countries. These countries then need to invest that money. They stick some of it right back into the US. But because US interest rates have been so low, they have also been investing in more ‘exciting’ assets, like sterling, resource currencies, and emerging markets.
Take away the dollars from the oil producers, and the flow of money into those markets gets reversed. As a result, commodity currencies and emerging markets tank. Which is what’s happened.
Meanwhile, anyone who has borrowed money in dollars, betting that the US currency would remain steady or weaken even further (a ‘carry trade’ in effect), is now on the painful end of a bad leveraged bet.
So with everyone getting jittery about ‘risky’ markets, and a general shortage of dollars in the world, the natural desire is to rush to the US – the ultimate safe haven.
How the ‘real’ economy could benefit at the expense of the financial one
I also wonder if there’s a deeper shift here. All those petrodollars were ultimately being spent on bidding up asset prices. As oil prices rose, those revenues were sunk into everything from high-end global property, say, to government debt. It’s a lot like quantitative easing, in fact.
If that reverses, you have less money available for financial assets. But in the case of oil, you also have more money for consumers. And if that boosts consumer demand, then in turn you might get more classic inflation – in consumer goods prices, rather than in asset prices.
And that in turn, would put more pressure on central banks to start raising interest rates.
That might take a while to play out, of course. But the strong dollar story isn’t going away. For more on how to play it, you should read James Ferguson’s recent story in MoneyWeek magazine. If you’re not already a subscriber, get your first four issues free here.
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