Guessing what the US Federal Reserve (Fed) will do and when it will do whatever it does has become a favourite game for traders and investors for several years. The Fed will hike rates. Or, the Fed won't hike rates. The Fed will hike rates by mid-2015. Or, the Fed will be "patient" and not hike rates until 2016.
Each of these statements has different implications for the global market. If the Fed hikes policy rates for the dollar, that will probably mean a move into US Treasuries for speculators. It could mean a further hardening for the American currency, also the world's reserve currency. Of course, the dollar is already at 12-year highs versus the euro and the yen. So, we can wonder how much further it could go up.
The impact of a Fed rate rise on equity markets is also significant. First, money moving into US treasuries implies money moving out of riskier assets like equity. So, it is generally assumed a dollar interest rate hike will mean a sell-off and a correction for global equities. Most equity markets are booming - a strange disconnect since most global economies are struggling. So, a correction looks over-due and it could be deep.
The European economy (meaning all the euro-denominated economies and also Scandinavians, Swiss, UK, etc) has been in a sustained slump. So has Japan. It is assumed, or rather hoped for, that activity will start improving if the euro zone and Japan gets a "grace period". Hence, traders would be happier if the Fed did not hike rates in 2015. Actually, to be blunt, most traders don't really care what the fundamentals may be. They would prefer interest rates to stay at zero or close to it for as long as possible.
The Fed has to carry out a balancing act. The US economy has been recovering. Jobs have been created steadily, at a good pace. The GDP has also been expanding quicker than expected. The Fed might want to raise rates by June-July 2015 in order to prevent possible overheating in the American economy. But such a rate hike could choke off growth across the globe and there is a point at which lower global growth will also hurt the US. The dollar is also looking too strong and America could start running up a huge trade deficit.
Nobody really knows what the Fed should do, in theory. Any action could be correct or wrong. What the Fed will actually choose to do is also guesswork. People will make guesses depending on what they know of the track records of the FOMC members and the Chairperson.
What we do know is there will be turmoil every so often on this account. There is a schedule of eight meetings. There will be extra volatility in currency, bond and equity markets centred around every meeting. There will be bearish trends before each meet for fear of a hawkish policy. There will be relief rallies if the Fed doesn't act hawkishly. There will be steeper, continuing corrections, as and when there is an actual rise.
This time, the Fed's decision will be known before you read this, and a clear trend could develop. But the next meeting in late April will probably see similar volatility again. One way to handle such high volatility is to use options. Buying strangles - long puts and long calls - exploits volatility without a view on direction.
Traders can target either equity indices, or currency pairs for volatility plays. Both corrections and rallies can be quite significant and given leverage, the trader could make a quick return regardless of what the Fed does.
The author is a technical and equity analyst
