Takeaways: An end to uncertainty, an effective vote of confidence and the repetitive use of the word ‘gradual’ by the FOMC inspired a brief rally in most equity and bond markets – even in some more vulnerable areas. So, is there really nothing to see here after their 0.25% increase in interest rates? Not quite. The impact may be more insidious than immediate. After nine years of falling and then rock-bottom interest rates in the world’s largest economy, the official direction of travel is now up – and that changes everything.
Given the long and well signalled build-up, the rather sanguine reaction to a US rate rise is scarcely surprising. There are two major releases this week. Both have been awaited for about a decade and the first increase in US interest rates since 2006 arguably had more trailers and certainly had more spoilers than the new Star Wars film. This rise really was priced in. The FOMC also went out of its way to emphasise that it would be cautious in its approach to further increases in what sounds like an exceptionally ‘dovish’ hike.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.
Indeed, if “remains accommodative” was the phrase of the evening ‘gradual’ was the word. The Federal Reserve will be well aware of central banks’ previous abortive attempts to raise rates since the financial crisis. But with so many domestic signals looking strong, it was arguably harder for it to wait much longer without it sending the wrong signal. It is interesting in the context of the reaction to a rise to ponder how markets might have reacted if the Fed chose to hold.
UK still likely to tread a middle way
Theoretically, this rise gives the Bank of England’s Monetary Policy Committee more room to move, in that it at least limits the possibility of a significant strengthening of the pound against the dollar should it follow the same path. But, the MPC will also be mindful of the ECB’s divergent loosening path and the potential for dearer exports to the Eurozone. Moreover, domestic concerns appear much more prominent their deliberations and, although unemployment is now at a ten year low, wage inflation and consumer price inflation also remain exceptionally low. This doesn’t appear that much of a game changer and we still expect the MPC to hold rates for most of 2016.
What arguably has more of a read through, is the expectation that US interest rates will top out at 3.5% – lower than before the crisis. This corresponds with expectations elsewhere that neutral or natural interest rates have fallen since the financial crisis. As the Bank of England’s staff blog noted earlier this year:
Analysis in the IMF’s 2014 April World Economic Outlook attributes the decline in global real rates since the 1990s to higher saving in emerging market economies, an increase in demand for safe assets, and a sharp and persistent decline in investment rates in advanced economies since the global financial crisis…..As a small open economy, the UK natural rate will be influenced by these global developments.
In other words, UK interest rates shouldn’t rise as high as they did before the crisis.
Before we all move on, we must highlight some on-going risks. It is positive that the FOMC feels confident enough to put US monetary policy on the path to normalisation. On the other hand, the fact that we have spent so long obsessing about one 0.25% interest rate rise is a measure of a prevailing uncertainty that will linger into 2016. Thus, although this first rise has arrived without immediate incident, we would guard against complacency. This long-trailed rate increase might not have an immediate drastic impact, but it could amplify future market stresses or setbacks. Future capital events for countries and companies will now be seen in the context of a rising US interest rate and that is a major change in market mind-set.
We’d also add a further risk in here. What the Fed means by ‘gradual increase’ and what market thinks it means are still different. Fed policymakers have pencilled in four further rate increases in 2016, according to their median forecast – one more than investors expect. Inflation is the main differentiator and – as with so much at the moment – this largely comes down to the oil price. If this stays low, inflation will remain in check and market expectations might be right. Then again, low commodity prices will also have an impact on the fate of emerging nations.
Again all seems well here so far, but this should be set in the context of a previous 18% emerging market currency fall against the dollar and a 17% drop in local equity market prices during 2015. The rate rise was obviously priced in and the Fed’s vote has inspired risk appetites this morning, but we’re not confident this enthusiasm will last into 2016. Fitch’s decision to downgrade Brazil to junk yesterday – joining S&P –highlights the continuing stresses on many emerging economies. A second junk rating automatically triggers asset sales for some pension funds, putting further pressure on an already weak currency and raising borrowing costs for Brazilian companies and its government. Many developing economies, like Brazil, still appear vulnerable to renewed dollar strength in borrowing costs and commodity prices.
Still watching HY
Corporate capital markets are also changing. Not so much now in investment grade, but – as we noted last week – at the riskier end of high yield there is a perceptible shift in attitude. Yields on bonds rated CCC or lower rose over 18% earlier this week — the highest level since July 2008. As Janet Yellen noted yesterday, the financial system is “more resilient”, which should “mitigate” against systemic risks but individual risks are heightened. According to BOAML, the debt burden of high-yield companies has risen to its highest level since at least 1998. Moody’s recently noted the unrealistic expectations of newly rated companies. High levels of refinancing during the period of easy-credit – and the continuing hunt for yield – means problems might take a while to play out; but leveraged companies will now need to prepare for much higher borrowing costs when they do come back to the market.
This is our last blog in 2015. I hope everyone enjoys a wonderful holiday break and I look forward to catching up with you in the New Year.