Markets totally Fed up, Yellen must hike rates

What is inevitable is that the next recession will occur - and perhaps in the not-so-distant future. After seven years of the US Fed cutting rates to zero, we are in an economic era which closely resembles the 1970s era of stagflation and associated with much poorer real economic performance. US Fed Chairperson Janet Yellen has not only to smoothen future volatility in markets but also build up ammunition to fight future economic slowdowns

It's that time again: Will they or won't they? In either case, the US Federal Reserve (Fed) and its Chairperson Janet Yellen are all set to destabilise the asset markets. The fact that this destabilising price action will play out sooner rather than later is the only silver lining of a potential 25 basis point rate hike on December 16.

First, let us examine the short-term backdrop of macro-events as we head into the FOMC (Federal Open Market Committee) meeting. We had the European Central Bank (ECB) disappointing financial markets by slashing its deposit rate by only 10 basis points and keeping its monthly bond purchases unchanged, although extending its QE (quantitative easing) programme until March 2017. Of course, these are dovish signals from Mario Draghi ( President of the European Central Bank) but hawkish with respect to market expectations. Hence, the market reaction was euro up, European stocks down.

Similarly, the Bank of Japan, Reserve Bank of New Zealand, Bank of Canada, Swiss National Bank and the Reserve Bank of Australia have also sounded less dovish than expected in recent weeks. It would be quite far-fetched to call this global central bank coordination but the fact remains that a Fed lift-off looks a lot calmer with the Dollar Index and US bond yields having cooled off over the past one month.

A rate hike with the euro/dollar at 1.1 rather than parity makes Yellen's job relatively easier as the strength of the greenback is not the top concern. Further, by signalling the hike as a dovish one, she will likely cap the gains in the USD. Markets are pricing in only about 55 bps a year of hikes over the next two years. The risks are, thus, to the downside and any delay in monetary tightening will most likely lead to a bigger leg-down in the dollar and equities. At this point, it is worth noting that many expect the Fed to hold ground in December and call the January meeting "live". This would not be a prudent step as the minute they announce the meeting is "live", the markets will readjust in a very volatile manner.

The other key question macro-strategists are asking with respect to the timing of the Fed lift-off is whether or not monetary policy will be back to "normal" at the onset of the next recession. Using NBER (National Bureau of Economic Research) business cycle dates, in the case of the United States, post World War Two period expansions have lasted from 12 months in the expansion ending in 1981 to 120 months in the expansion ending in 2001. The current expansion is already 77 months long, longer than the previous 2001-2007.

While this extrapolation may be too simplistic, what is inevitable is that the next recession will occur - and perhaps in the not-so-distant future. After seven years of the US Fed cutting rates to zero, we are in an economic era which closely resembles the 1970s era of stagflation and associated with much poorer real economic performance.

Pressing the lift-off button after years of financial markets being addicted to easy money, Yellen is not only smoothening future volatility in markets but also building ammunition to fight future economic slowdowns. The time is the right for a lift-off. Expect the monetary divergence to be the main macro theme in 2016 yet again if Yellen hikes.

By Vatsal Srivastava