How To Set Up Against Either Side Of Thursday’s Interest Rate Decision

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interest rates

The upcoming US interest rate decision is one of the most widely anticipated economic decisions of the last two decades. However, while the fact that it is about to take place is well-known, its implications are far less certain. This is the case even for those pretty well versed in economics and financial asset markets. With this said, there are a few ways we can set up against the rate decision in anticipation of a range of scenarios, which should serve to maximize our upside in the event that the decision comes out in our favour, and minimize our downside in the event that it does not. So, let’s try and figure out the un-figureoutable.

First of all, why all the uncertainty? Well, interest rates have long been the primary tool for the central bank of an economy to maintain economic stability. When interest rates are low, an economy generally expands, but in order to maintain stable inflation (generally around 2%) a central bank will normally raise interest rates to reduce borrowing and – in turn – private and public spending. You can think of it as a kind of “letting off steam for an economy”. So, since an increased rate hike generally means less industrial and private industry spending, stock markets will normally correct as interest rates increase. Conversely, since interest rates are the primary determinant in the value of a nation’s currency, currencies will usually appreciate in value as interest rates rise.

Things are different, now, however. Inflation is non-existent in the US, so we have this disparity between domestic equities markets (which have been booming for the last half decade), unemployment levels (which are – according to figures, at least – at reasonably low levels), inflation (which as we mentioned is pretty much non-existent) and economic growth (which again, is zero or negative at present).

The question is, then, is the US economy strong enough to withstand a rate hike? Alternatively, will downside pressure on private industry’s ability to borrow money and expand reverse the nation’s fortunes and send it back into recession? This is what nobody knows, and is the root of the dilemma.

So how can we set up against it? Well, normally, in anticipation of a rate hike, investors will shift assets from risk on to risk off, or in other words, out of equities markets and into gold. This is rooted in the fact that equities will generally sell-off as the rate hike constricts the flow of free capital into and out of markets. However, some will argue at the moment that a rate hike reinforces the Federal Reserve’s confidence in the US economy, and can be translated as bullish for its domestic equities markets. Why? Because there is a long way to go before we get inflation and growth. A rate hike now could suggest that we are on the path towards, but far from actually at, the end of the current bull market.

Conversely, loose monetary policy will generally boost stock markets as it suggests a continuation of free capital flow. However, in this instance, it could suggest that the Federal Reserve is taking the lack of inflation seriously, and that it believes it could be a problem going forward. For this reason, equities markets may correct in spite of the loose monetary policy, which again, could lead to an uptick in gold.

So how can we play it? Probably the safest approach is to allocate a majority portfolio to precious metals SPDR Gold Shares (NYSE:GLD) and certain areas of US industry that are relatively immune to the wider economy – health care, insurance etc. Energies are a risky allocation at the moment, and while we will likely see a spike if the Fed raises rates, the questions over how long that spike will remain in place make any exposure to them uncertain. What about those looking to get a piece of the action we are likely to see in equities markets if rates remain low? Major indices – Dow Jones Industrial Average (^DJI), NASDAQ Composite (NASDAQ:^IXIC) – remain the best bet, as these offer upside as part of a wider market buy in in the event of loose monetary policy, but also a (somewhat) protected downside as a result of the blue-chip nature of their constituent entities.

All said, tomorrow is going to be a pretty volatile day regardless of what happens. For those not looking to take an active approach, a majority cash holding might be a smart move, and one that retains capital that then becomes available to allocate in response to post-announcement market behavior.

 

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