Stocks rise to close the week ahead of the Fed’s decision next Thursday. The S&P500 added 0.5% to 1,961 and the Dow Jones gained 0.6% to 16,433. Fed funds futures currently indicate a 30% chance of a rate hike next week, which has decreased significantly from before China’s collapse last month. The labor market has reached a level in which tightening may be appropriate, however inflation levels still remain quite low. Outside of the Fed’s dual mandate, international turmoil is something to consider as well. The VIX continues to drift downwards to 23.43, closer to recent normal levels but still elevated. The two year yield fell 2 basis points to 0.71% and the ten year yield fell 3 basis points to 2.19% as investors price down tightening next week. Similarly the dollar lost 0.3% versus peers.
In spite of some expectations that the Fed will not tighten next week, it is still important to identify how certain asset classes will perform in a rising rate environment. The US dollar is expected to appreciate following an increase in rates, as international investors will be attracted by higher yields in the US. The rising dollar is expected to put downward pressure on commodities. Commodities are priced in dollars, so as the dollar appreciates it becomes more expensive for international investors to buy commodities. This reduces demand for commodities, therefore affecting price in a negative manner. As funds flow into the US from around the world, this is expected to put downward pressure on emerging market currencies. This poses a negative affect to emerging dollar debt, many of which is denominated in dollars which it more difficult for issues to make payments when the dollar rises. Affects on domestic fixed income markets are more obscure. When interest rates increase prices will decrease. This may result in investors selling bonds, and do to low liquidity in markets could lead to further losses. Sell side bond trading has decreased while the buy side and issuance has increased. This leads to a potentially dangerous mismatch in the event of large scale market panic. The scale of this dynamic will largely depend on how much increases in yields are offset by buying pressure from international investors seeking high quality returns. Equity markets will largely depend on what happens in fixed income markets.
Oil production is set to decrease over the next year as low prices begin to reach producers. The International Energy Agency suggested in a report that the US shale industry has faced sharp cutbacks as Saudi Arabia has maintained production in order to keep market share. Saudi Arabia and other OPEC countries by maintaining their own production are putting heavy pressure on US producers by driving prices so low that it no longer makes sense to produce given drilling and exploration costs. Global demand is expected to reach 1.7MM barrels per day next year (a five year high) and fall to 1.4MM the year after, which is still considered strong. Production from OPEC and non-OPEC entities continues to stay ahead of demand therefore putting downward pressure on prices for the time being. Goldman’s 2015 price forecast for Brent oil was recently cut to $53.70 and the 2016 price down to $49.50. WTI was cut for 2015 to $48.10 and to $45 for 2016.