Meet the Federal Reserve's All-Important Neutral Rate

This is what central bankers are looking to for policy.

Manual worker breaking up large percentage sign
Future Interest Rate Expectations in the US Continue to Fall Thanks In Large Part to the Neutral Rate. Getty: Gary Waters

Trading is a difficult sport. One of the biggest challenges is trying to figure out how central banks will set up the playing field for your trades. Since central banks determine interest rates and over the last seven years have brought monetary policy into play that was previously thought unthinkable, the game is changed. Not necessarily for the worst, though many would disagree, it has changed for sure.

One of the biggest questions following the December 2015 Federal Reserve rate hike was when the next hike would be? The implications of the answer are significant as any Forex trader knows. Multiple increases of the Federal Reserve’s reference rate will lift up the value of the US dollar significantly.

The world witnessed an adamant rise in the price of the US dollar from summer of 2014 to March 2015. Over this time, US companies complained about a competitive disadvantage in exports and at the same time, many international corporations and countries that borrowing US dollars complained because their ability to pay back the US dollar based loan became increasingly difficult.

Since March 2015, the US dollar has moved sideways stability has allowed companies a bit more flexibility than the sharp price increase allowed in summer of 2014 to 2015. An insightful quote from Dallas Federal Reserve Bank President Robert Kaplan in August 2016 was on how “sudden traumas in the foreign-exchange market can make China’s economic adjustments more challenging.” As you can imagine, given the money China has they are likely more flexible than other emerging markets.

Therefore, what negatively affects China negatively affects other emerging markets and some developed markets as well.

The Future Path of Interest Rates And What It Means to FX Traders

If you have gotten this far, congratulations. That is not an easy intro, but it is important to understand what lies at the core of the Federal Reserve’s understanding of the neutral rate as of August 2016.

Because of globalization and the easy transfer of money across borders, interest rates and economies have become increasingly important. High-interest rates and make borrowing and economic growth more difficult, and too low-interest rates prevent other forms of investment in countries and reduce revenue from the finance sector.

Most developed market economies have historically low-interest rates at the start of last half of 2016. Two major economies, Europe and Japan, have negative interest rates that have ironically led to very strong currencies. The United Kingdom economy is suffering from confusion following the Brexit vote. While the United States is trying to figure out if they can depart the course of action of other central banks, which has been continued easing to move to a more restrictive policy.

The way the Federal Reserve has described how they are determining if the economy can handle a rate-hike or a series of rate hikes is by understanding the neutral rate. The neutral rate has been described as the rate that signifies the dividing line between an accommodative and restrictive monetary policy. The neutral rate is known as an unobserved rate meaning that there is no unified or central agreed-upon number for the neutral rate.

Put another way; it is not a number you can look up on the Bloomberg terminal, but rather is found through a combination of inflation and employment reports and other growth factors.

The significance of the neutral rate is in its relation to the Federal Reserve’s reference rate. As an example, if the Federal Reserve’s benchmark rate was 1% (as of this writing it is at .375%), and the agreed-upon neutral rate was 2%, and the Fed would be seen as providing an accommodative monetary policy to stimulate economic growth. However, if the Federal Reserve’s reference rate was 1%, and the agreed-upon neutral rate was 0.5% in the Fed would be seen as providing a restrictive monetary policy to stimulate economic growth. Because central bankers aim to provide a monetary policy that is accommodative when the economy is not operating at full employment, or the trend of inflation is below target, this becomes very important.

Over the past several years, the neutral rate has continued to decline, which makes a series of rate hikes higher less likely. One way this can easily be seen by a trader is through the US Treasury two-year yield. Forex traders will often look at the two-year yield for any country to get a taste for what fixed-income investors expect interest rate policy to be two years from now. In June 2016, when the Brexit vote passed, the United Kingdom two-year Gilt yield plummeted from 0.55% down to a low a few days after the Brexit vote to 0.04%. Much of the decline in yield, which is inversely related to price, was due to widespread belief that the Bank of England would cut rates (which they did) and introduce a package of accommodative monetary policy be a stimulus (which they also did.)

If you do not favor looking at two-year yields of government debt, you can also look at Treasury Inflation Protected Security yields also known as TIPS. Both TIPS and two-year yields have remained lower than many people expected because of the falling neutral rate, which has worried central bankers.

Why the Neutral Rate Is Falling and Central Bankers Are Worried

So why is the neutral rate falling? The question is much easier to ask them to answer, but we have some very good ideas as to why this is happening, and you are encouraging. In a speech on August 2 in Beijing, Dallas Federal Reserve President Robert Kaplan noted that a major driver in the decline of the observed neutral rate has been lower estimates of economic growth.

Rate hikes typically happen to prevent economies from overheating. As long run estimates of nature growth decline, the need for restrictive monetary policy also declines. In addition to lower estimates of future growth other attributed factors to lower neutral rate have been demographics in advanced economies showing smaller families and more retirees as well as lower productivity among workers. Two more factors mentioned by Mr. Kaplan is the decrease in pricing power companies have thanks to technological advances that allow tumors to have a better understanding of available pricing and the high levels of debt that companies and countries have taken on post a Great Financial Crisis that will have to be serviced instead of future growth projects.

Given the reasons above for a lower neutral rate, it stands to reason we could be entering into a new age of very low-interest rates in developed economies. Historically, foreign-exchange markets have provided very favorable trends based on monetary policy divergence. In fact, many investors and FX traders have anticipated monetary policy divergence to lead to significant strength in the US dollar relative to other currencies such as the EUR and Japanese yen.

The divergences failed to materialize as many believed it would in large part because the Federal Reserve is unwilling to create that divergence monetary policy through aggressive hikes to the reference rate. Given the low neutral rate, it is hard to blame them for being reluctant to stomach the thought of multiple rate hikes if the neutral rate continues to fall and other economies are experiencing falling GDP forecasts.

It is unlikely that this mean will never see another interest rate hike. However, it is easier to argue that we will likely fail to see rates at 3% in the United States anytime soon. 3% is the long run projection the Federal Reserve has per the Dot plot provided after some Federal Open Market Committee meetings.

What Does This Mean for FX Traders?

Forex traders that expected monetary policy divergence have naturally been disappointed. The failure of monetary policy divergence has also brought a failure of very strong trends in the FX market. The strongest trend of 2016 so far has been a very weak British Pound, which developed on the back of the presumed-unlikely Brexit outcome. We have also seen a very strong Japanese yen, which appears to be the result of negative interest rates leading to money flowing back into Japan from Japanese corporations to shore up their balance sheets.

Other than the British pound and the Japanese yen there has been very little movement in major currencies like the EUR in the USD. Should the neutral rate continue to fall, which would likely encourage the Fed to act less than they previously thought they would, we could be in for many more quarters for years of range-bound markets in FX.

Many investors have begun to turn to emerging markets, which have higher yields to prevent inflation from overheating, and who have fewer of the negative drivers of the neutral rate as a burden. As an example, the demographic environment in many emerging markets is incredibly favorable for long-term strong economic growth.

Of course, there will always be trading opportunities but among developing markets, they may take place over weeks and sometimes months as opposed to over many quarters and many years like they did historically. As a trader, we must always adapt and if the neutral rate continues to fall adapting to a shorter-term trading strategy will likely be a requirement.

Many readers of likely become aware of high-frequency trading and quantitative traders that try and strip out fundamentals and technical analysis for machine learning artificial intelligence to drive an edge, which is the opposite side of the spectrum of the long-term trend trader. Many traders will likely find a home somewhere in the middle or closer to the very short-term traders.

Other traders who want to stick to medium the long-term trading will likely have to look to new currencies that they have not traded before their house and emerging markets. Some long-term trends that have developed in 2016 have been the strengthening South African Rand and Russian Ruble. Both currencies are strongly tied to commodities and growth from other emerging markets like China.

Either way, it appears the neutral rate that many of you have for the first time been introduced to may change the way many of us approach the FX market.

Happy trading!