17th December 2015
On Wednesday, as widely expected the US Federal Reserve finally raised interest rates by 0.25%.
The cost of borrowing in the world’s largest economy has been at near zero since 2008 and the last time the central bank upped interest rates, was back in 2006. We round-up expert reactions to the move…
Dominic Rossi, global CIO, equities at Fidelity International:
US consumers are entering 2016 stronger than in they have been in a decade. US consumption will easily be able to weather the expected modest interest rate increases and the domestic economy may well turn out to post a surprisingly strong performance.
The strength of the domestic economy leaves the US equity market better placed to cope with tighter monetary policy than other markets. This means that in US dollar terms, we can continue to expect the US market to outperform.
Adrian Lowcock, head of investing, AXA Wealth:
The rate rise announced on 16 December was generally expected and therefore largely priced into stock markets. However there is clearly some relief that the Federal Reserve have finally begun to raise interest rates after holding back in September. The Federal Reserve has indicated interest rates will rise slowly from here and expect them to eventually peak at around 3.5%.
Investors should invest wisely during this next phase of recovery following the financial crisis. This is new ground and no-one really knows how the US businesses and consumers will react to interest rate rises. Ensuring you have a diversified portfolio including defensive assets will protect you against any fallout from government policy error.
David Lloyd, head of institutional public debt portfolio management at M&G Investments:
The 25 basis points rise in US official rates was almost entirely expected, so the absence of any significant negative reaction in the markets is not overly surprising. The accompanying statement contained no meaningful revisions to earlier economic forecasts, nor to the expected future course of rates.
So far, so benign. However, there are three issues, beyond the outlook for the real economy, that complicate things somewhat.
Firstly, the state of the global economy – China in particular – has the capacity to affect the Fed’s future deliberations, particularly in the event that renewed weakness unfolds.
Secondly, there is what we might call the asset economy. It seems likely that low rates will have caused some investors to take extra (and, perhaps, unfamiliar) risks in pursuit of yield. Similarly, some players may have taken advantage of minimal rates to increase borrowing (leverage). It will take some time before we will be in a position to assess the effect of higher rates on such decisions. The Fed will be watching closely.
Thirdly, there is the tightening mechanism itself. Many analysts believe that the Fed will only be able to make the rate hike “stick” by withdrawing liquidity. Again, it will take time to observe and assess these issues, but any significant withdrawal of liquidity may well prompt bouts of market volatility.
For pension funds, today’s events do not – yet – represent a watershed. The prospect of modestly higher rates and government bond yields should come as a surprise to no-one. For investment grade credit markets rate rises are, to an extent, a vote of confidence in the health of economies and, by extension, in the health of borrowers. Value is becoming increasingly apparent as credit spreads have widened recently. Clearly, High Yield is experiencing volatility but this is, of course, primarily caused by weak commodity prices.”
Ben Brettell, senior economist at Hargreaves Lansdown
An interest rate rise is a new experience for much of Wall Street. A whole generation of traders have never known anything but the post-crisis world of ultra-low interest rates and, for the most part, rising asset prices. An estimated two-thirds of traders have never seen a full Fed tightening cycle.
The Fed’s historic move is largely symbolic. Incredibly it’s been seven years since Ben Bernanke announced US interest rates would be cut to historic lows of 0-0.25%, ushering in the current era of extraordinarily loose monetary policy. It’s the first sign that the patient is recovering well enough to be weaned off the medicine.
Notwithstanding today’s 25-basis-point rise, US monetary policy is still extremely loose. Just like counterparts at the Bank of England, members of the FOMC have been at pains to point out that the tightening process will be gradual.
While the US economy is certainly moving in the right direction the recovery remains tepid, and yesterday’s inflation figure of just 0.5% gives the Fed plenty of room to leave rates lower for longer. According to its own projections released in September, the Fed expects interest rates to be 1.4% by the end of next year and 2.6% by the end of 2017.
The Fed’s move it makes life easier for Carney to push the red button on UK rates:
Where the Federal Reserve leads, the Bank of England could follow, but not just yet. The Fed cut rates to near zero in December 2008, and the Bank of England cut to the current 0.5% three months later in March 2009. As such today’s hike from the Fed opens the door for the Bank of England to make its first move next year.
However inflation has been basically stuck at zero since February, wage growth has come off somewhat and productivity remains a puzzle. Against this backdrop borrowers will dine out for at least the first half of 2016 without a cost rise, where as savers will remain decidedly in the doldrums.
Tighter US monetary policy could have negative consequences outside its borders. Emerging economies in particular could be affected by higher interest rates in the states. Low US interest rates have encouraged borrowing in dollars, and this capital has flowed into emerging markets in search of higher returns. When US interest rates rise, capital flows could reverse, weakening emerging market currencies and making dollar-denominated debts harder to service.
James Dowey, chief economist and CIO of Neptune Investment Management:
The Fed has done a good job of combining this first rate hike of the cycle after seven long years on the zero bound with enough dovish messaging to take the sting out. To achieve this it stated that the path for the Fed funds rate from here will be “gradual”. At the same time, however, it threw a bone to the hawks by sticking to its four hike-projection for 2016, as implied by the median projection of the FOMC members – four 25bp hikes taking the Fed funds rate to 1.375 by end 2016.
What does this combination of signals mean for the path of rate hikes next year? “Gradual” means shallower than previous cycles. During the past four, going back to 1988, rates were hiked on average by 2.6% during the first 12 months, ranging between 1.75% in 1999 and 3.25% in 1988 – so the Fed’s language is perfectly consistent with its dot projections, and optimists who believe the economy is healthy enough to withstand it should take four 25bps hikes in 2016 as their roadmap.
We believe that the market is only pricing in just over two hikes in 2016, because the consensus is putting quite a lot of weight on the possibility that the US economy will struggle with rising rates. Note that it follows from this that if the economy is indeed able to absorb these hikes then the market will be surprised positively by a growth tailwind to offset the cost of capital headwind, so should not be hindered by the macro overall.
Salman Ahmed, global strategist at Lombard Odier Investment Managers:
Given the highly telegraphed and forewarned nature of the decision, it is unsurprising to see muted bond market reaction to the decision. Ms. Yellen spoke to a variety of audiences in her remarks ranging from markets, investors, international actors to common Americans. She also explained in detail her concerns (both positive and negative) and how future shocks could force shifts in policy in either direction. However, mostly importantly, she managed to convince her diverse audience that policy will remain easy and any hiking from here on will be gradual and data dependent. With this key decision out of the way, we think the focus will turn on fundamental developments both in the US and internationally, which will shape both policy and market outcomes going forward.
Here, the picture remains mixed with continued concerns around China coupled with renewed fall in commodity prices which has contaminated the financing environment. With concerns around the health of the global economy firmly in place, the Fed has managed to deliver a very neutral start to the hiking cycle. This should certainly help to reduce one important source of uncertainty, which has been dogging risky asset markets for nearly a year.
Edward Smith, asset allocation strategist at Rathbones:
Historically, global equity markets tend to do well for at least a year after the Fed sets off on a rate-rise cycle. Even in 1994, when Alan Greenspan surprised investors with several rapid unheralded hikes, the S&P 500 closed higher a year later, although other countries’ bourses fared worse.
Taking into account data going back to 1990, the best conditions for equity returns have been when interest rates are increasing and growth is rising. It is wrong to assume that tighter monetary policy means lower equity returns, per se.
It’s not the nominal interest rate that matters so much as the gap between the lending rate and the rate of return on capital. A very healthy cushion remains between these two measures, which should support equity markets during the earlier phase of the tightening cycle.
One of the most important drivers of equity returns is economic growth – particularly upward surprises. The outlook for global growth is much less certain than the direction of US interest rates, and this is what investors should be focusing on. GDP expansion should be marginally higher next year, but some of that is due to a less severe drag from the slowdown in China, and recessions in Russia and Brazil.
We’re looking to a nascent recovery in the eurozone, and the long-awaited consumption effects of the oil price plunge – historically they tend to come through a year later than the negative effects from capex cuts – to also improve upon 2015’s growth rate.
Finally, corporate cash piles have been growing over the past few years as companies refuse to invest. Our research shows companies usually start returning capital about two months after Fed rate hikes. This may be driven by managers looking to put money to work before the cost of capital eclipses the potential returns.
Those companies with the ability to grow dividends and continue to buy back shares could be rewarded by investors, while those that can’t may be found naked when the tide goes out.