Stefano Fugazzi (ABC Economics) – The Federal Reserve is laying the groundwork for the first interest rate hike since 2006. Markets expect Fed Chair Janet Yellen to increase rates above the current 0,00-0,25% level as early as this spring provided that inflation returns to 2%. If the move is confirmed, the Fed would be the first major central bank to increase rates since the subprime mortgages bubble burst.
Stanley Fischer, vice chair of the Fed’s board of governors and voting member on its policymaking committee, suggested that that there is a “high probability” of a rate increase this year as the U.S. economy is “very close” to achieving a natural rate of unemployment and that inflation should rise as the effect of low oil wears off “in a couple months, so it’s about time”.
However outside experts, including Nobel prize-winner Paul Krugman, have warned that high levels of debt among many US households would make an early rate rise risky. Nevertheless a rate hike is expected at some stage in the near term.
The purpose of this paper is to estimate the financial markets reaction to the Fed’s announcement.
To do so we observed all rate increase instances since 1995 where a rate increase was announced.
We examined 24 events in total from February 1, 1995 to June 29, 2006 (see Table 1) and measured how the Standard & Poor’s 500 (S&P 500) , NASDAQ 100, NASDAQ BANK, NASDAQ INSURANCE indexes, in addition to the GBP/USD cross rate, reacted to the announcement of interest rate variation.
Relative to the 1995-2006 period, on average the NASDAQ 100 outperforms the S&P 500 and the NASDAQ sub-indexes.
Within the dataset we observed that interest rate increases generated higher positive variations in the years preceding the dot-com bubble burst.
On average the NASDAQ 100 yield a +3,35% return over a 2-day horizon between February 1995 and March 2000. The average returns were non-significant (+0,02% overnight change) or negative (-0,22% 2-day horizon) post-2000.
A similar pattern was found in the other indexes we examined (please refer to the table reported below).
In respect of the GBP/USD cross rate, a positive variation in the interest rate would generally lead to the appreciation of the UK Sterling against the US Dollar with an average 2-day increase of 0,18% (0,26% pre-dotcom bubble and 0,14% thereafter).
Our 2015 prediction
ABC Economics agrees with Paul Krugman’s assertion that an imminent rate increase would be premature as US inflation is yet to reach the Fed’s 2% target (see http://www.usinflationcalculator.com/inflation/current-inflation-rates/). However, should Janet Yellen go ahead and swiftly announce a 25 basis point hike ABC Economics would expect the markets to yield null or negative returns over a two-day horizon.
Stefano Fugazzi (ABC Economics), 1 March 2015