Fed up

December 18, 2015 11:00 AM

The machinations surrounding the multi-year speculation regarding when the Federal Reserve would raise interest rates got old a long time ago. While there was great anticipation for a September rate increase that did not come, the surprisingly strong October employment situation report released in early November appears to have locked in a December tightening. 

The problem is that a September tightening was pretty much locked in back in August, which was a major contributor to the August correction. As of this writing there are more than four weeks until the December meeting; a lot can go wrong in four weeks. Perhaps the Fed should have ended the speculation and raised rates the Monday after the October report. The S&P 500 closed the week ending Nov. 13 down 80 points. How much worse could it have been? It may have sparked a relief rally.

In our annual Top 30 Brokers feature we discuss the key issues affecting the futures business with the heads of numerous futures commission merchants (FCMs). Higher interest rates was at the top of most of their wish lists. Of course, that could probably be true of this feature in each of the last six years. 

A hot topic was the attrition in the FCM space. We illustrated how the number of registered FCMs has dwindled to 69 in August 2015 from more than 150 a decade earlier. While all futures brokers would like to see interest rates rise as earning interest on customer assets—the float, which had long been a profit center for futures brokers—those that depended on it are the ones that are no longer on the list. 

During the years FCMs have had to adjust to the fact that they would not be earning much interest on customer assets. Those that have not been able to adjust are gone. Many of the survivors have said as much over this period of zero interest rates. 

However, this year there was actual anticipation of relief. Fed Chair Janet Yellen stated several times this year that she anticipating raising rates in 2015. And now, barring another surprise, it will happen in December. 

Here’s the thing, though, it is not that rates are going to go up to some level that could be charitably described as normal. The craziest thing about this long speculative period is that it is all has been about when the Fed would raise rates a measly 25 basis points. And while the Fed has been insisting that they are very close to being ready to raise rates, they also have been assuring the market that it will be slow and methodical.  About a year ago we published a piece where our experts predicted the Fed would raise rates an average of 100 basis points a year once the tightening cycle began. This was a much slower pace than the last tightening cycle when the Fed raised rates a quarter at every meeting over a couple of years. 

“Is this what we have in store?” shows the anticipated increase in Fed Funds as measured by the Fed Funds Futures contract. The black bar at the top indicates a better than 70% chance that the Fed will raise rates by a quarter at its December meeting. The dark grey bar immediately below that indicates a Fed Funds rate between 75 and 100 basis points in January 2017, suggesting the Fed would only raise rates 0.5% in 2016. Remember, this is coming from basically zero. The light grey bar at the bottom shows that the rate would still be below 2% by mid-2018. While there has been great anticipation of rates finally moving higher, in reality this isn’t a whole lot of relief but a promise of extremely low interest rates for years to come. 

Of course, if inflation picks up one would anticipate rates rising more quickly, but no one would have anticipated back in 2008 that rates would remain at zero seven years later. We have had recessions where interest rates bottomed at 3%. Is it possible we can have an entire economic cycle—recession, recovery and recession—where rates stay at zero?

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.