As Federal Reserve monetary policy further cements its impact on currency markets, forex players have no choice but to scrutinize every signal subtlety communicated by policymakers. Yet, at a time when Fed officials maintain tremendous operational and rhetorical balance, traders and analysts may find little clarity in the message of the U.S. central bank.
Nevertheless, by looking at the historical pattern between interest rates, stocks and the dollar, traders cannot only decipher the proximate timing for shifts in Fed policy, but they also can draw conclusions on the likely direction of the U.S. stock market and the U.S. currency. By examining the relationship between the Fed Funds relative to long yields, the S&P 500 and the ISM manufacturing survey since the last two easing cycles began in 1998, we can isolate this connection.
Accordingly, we expect the Fed to continue shifting away from a tight policy stance and eventually begin easing rates as early as the current quarter.
“Delayed reaction” (below) suggests the following:
1. It took less than seven months for the Federal Reserve to start cutting rates in 1998 and 2001 after the Fed funds rate stood persistently above 10-year Treasury yields. In 2005, the Fed funds rate breached and remained above 10-year Treasury yields in July when the Fed raised rates to 5.25%. A six- to seven-month lead-time suggests a Fed rate cut in January this year, as there is no Federal Open Market Committee (FOMC) meeting scheduled in February.
2. The Fed’s 1998 rate cuts started two months after the peak in the S&P 500 index, while the Fed’s 2001 rate cuts began roughly four months after the peak in the S&P. Using this two- to three-month rule of thumb, and considering that most technical measures of the S&P 500 have begun signaling overbought and slowing momentum conditions, we deduce that the Fed would start easing as early as the Jan. 31 meeting. Indeed, the relative strength index of overbought/oversold conditions shows the S&P 500 weekly chart at its most overbought level since February 2004, after which the index fell into an eight-month bear market, losing 9.0%.
3. It took three to four months of sub-50 ISM manufacturing surveys before the Fed began cutting rates. Although manufacturing occupies a decreasing share of the economy, at less then 15%, the erosion in manufacturing jobs remains noticeable on personal consumption. With the latest ISM manufacturing survey below the 50 level for the first time in 3-1/2 years at 49.5 in November, this boosts chances for a January rate cut if the December ISM, which is due early January, remains below 50. Two more surveys of sub-50 readings would be consistent with a first quarter rate cut in 2007 because the ISM manufacturing survey had historically preceded rate cuts with a three to four month lead time.
Interestingly, these patterns are taking place today. The Fed funds rate remains well above long-term yields, the manufacturing ISM IS at multi-year lows and U.S. stocks have already begun selling off.
While this analysis helps estimate the timing of the first Bernanke rate cut, it contains no indication on the dollar’s likely behavior. “Dollar direction” (right) shows the relationship between the dollar and the last three Fed easing cycles: 1995-96, 1998 and 2001-02.
We have raised the probability of a first quarter Fed easing to 85%, with a 55% chance of a rate cut at the Jan. 31 meeting. Due to the inflationary realities emerging from a possible rebound in oil prices, a rate cut should not be considered a signal of the beginning of a concerted easing policy. This year may also mark the time when Fed Chairman Ben Bernanke begins pushing his inflation-targeting doctrine toward members of the FOMC and the public.
No analysis on the Fed’s policy cycle should be considered without heeding the labor market. Despite upward revisions in non farm payrolls in recent months, the evidence of a slowing trend in payroll creation remains unambiguous, while the slump in goods producing and manufacturing jobs is already reflected in the national and regional ISM surveys.
But as “Unemployment gauge” (below) shows, the Fed hardly ever began cutting interest rates without the unemployment rate registering a rise of at least 0.2% points. A recent exception, however, took place in November 1998, when the Fed eased rates despite a drop in the jobless rate — an effort to inject liquidity to encounter the Long-Term Capital Management market meltdown. That exception was corroborated by the 1998 easing being largely market-driven and not economic driven.
With the economic pieces increasingly pointing to a deepening slowdown in the U.S. economy, a rising unemployment rate will be amid the final signs of confirmation calling for the Fed to step in. Last year’s dip in the unemployment rate to a 5-1/2-year low of 4.4% from 4.6% may have presented an obstacle to forecasts of a January easing. But it also signaled the confirmation of the peak in the labor market.
The decline in 10-year yields below the Fed funds rate throughout the past year has served as an effective mechanism for tightening economic and market conditions throughout 2006. The Federal Reserve’s transition from a hawkish pause to a more neutral pause was in line with the cooling economic and market conditions and consistent with the easing cycles of 1998 and 2001.
Similarly, the dollar decline, typical of a post-tightening pause period, may have run its course for most of the fourth quarter. Unless the Federal Reserve signals a prolonged easing cycle next year, the dollar should begin stabilizing. The increasingly data-dependent Bernanke Federal Reserve is not expected to engage in prolonged policy changes without clear signs of expansion or contraction. With the core PCE remaining at uncomfortably high levels, the dollar may put time on their side, but this also means the worst is not yet over.
Ashraf Laidi is the chief forex analyst for CMC Markets.