FOMC COMMUNICATION AND INVESTOR’S DILEMMA – BY Dr. BOBBY SRINIVASAN AND Dr. SUDHAKAR BALACHANDRAN

October 14, 2014 | Posted by bobbysrinivasan << back to blog

Forecasting interest rates can be a humbling experience. For example, the Wall Street economists had predicted higher interest rates after the tapering ended by the year end and it has not happened yet. The US Federal Reserve announcement has upped the ante, telling investors to look for higher interest rate in the near term. The impact of this announcement has seen both the euro and the Yen drop in value. The euro dropped from 1.37 and 1.27 in less than 2 months and the yen from 104 to 109 to a dollar.
The bond market reacted to the Federal Open Market Committee (FOMC) announcement that the interest rates are heading higher. The bond traders who pushed up short-term treasury yields and adjusted the interest rate futures bet across the next 5 years. The policy sensitive two-year Treasury note has now raised to a level seen in May 2011, when hopes of strengthening economy were high.
While the treasury market reflected the basic thinking that the economy has bottomed out and the growth in the US economy is waiting to happen, Janet Yellen, Chairman of the Federal Reserve, advised caution and advised the bond traders to be cautiously optimistic. These words increase the ambiguity about the future interest rates. It is often said and I quote “ambiguity is part of life, either as a central banker or investor.”
She also said that in the event “the economic activity engages a higher gear” the policy makers would implement a sudden shift by pushing up the interest rates. Right now, the US inflation rate is running below the Fed’s target and increasing the interest rate at this juncture would push the inflation rate even lower. We should remember that the current Federal Fund’s rate has been stuck in the range of zero to 0.25% for nearly 6 years.
Summarizing, the bond traders seem confused not knowing as to how to react to the Federal Reserve signal. FOMC, for example, has lowered its expectation of the economic growth rate to 2.8% during 2015 rather than the previous 3.1%. They would like to see a higher inflation rate which is not happening. They are also not clear about the implication of tapering off QE3.
Lesson: The FOMC like every bond trader is waiting for the data on the future non-farm payroll, CPI, PPI, etc. before they will call the shots.
Observation: Both the bond and currency traders are equally uncertain about the future economic growth as well as the inflation rates.
The FOMC policy will have an impact on the Indian economy and the stock markets. If, indeed, the interest rates head higher in the US, some of the FIIs may take the money off the table and that will push the sensex down along with the weakening in value of rupee against the dollar. Consumer savings rate in the US is running very low and they may decide not to increase spending until the savings rate picks up significantly. After all 72% of the US GDP comes from consumer expenditure. Finally, never in the history of financial markets predicting future US interest rate has become such a challenge. This has increased the suspicion that the global economics are all painfully adjusting to lower growth for many years to come. Recession is the last thing the world wants.

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