The U.S. Federal Open Market Committee (FOMC) raised rates by 25 basis points (bps) as expected on 16 December, moving up from the near-zero rate band the country has been mired in since the financial crisis.
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Where does the central bank of the world’s largest economy go from here? And can they walk the line between too fast and too slow? Experts from a cross section of BNY Mellon’s boutiques express their opinions.
The first hike in U.S. interest rates since 2006 was largely expected by the market after the Federal Reserve (Fed) sent a strong signal following October’s FOMC meeting. In fact the major world markets ended (or opened) higher following the announcement, the U.S. dollar posted gains versus the euro and the two-year Treasury yield rose above 1% for the first time since 2010.1
Yet there remain questions around whether the global economic backdrop truly warrants monetary policy normalization in the U.S., if the Fed has moved too soon and whether there will be unintended consequences from the move.
Sinead Colton, head of investment strategy at Mellon Capital Management*, says the Fed did a good job of setting the expectations of investors ahead of the December meeting, which is why, she believes, there was no significant initial reaction in either bonds or currencies. “Given the underlying strength of the U.S. economy and the Fed’s expectations for inflation, there was no reason for them to delay a rate increase as they did in September. Recent volatility has been much less significant than what we saw in August and September.”
However, Peter Hensman, global strategist and economist at Newton Investment Management, believes the Fed had talked itself into a corner and would have caused itself more problems if it hadn’t raised rates this month. Even though, he says, in his opinion the factors that had caused it to delay liftoff through 2015 have probably deteriorated rather than improved.
Hensman believes the Fed was desperate to raise rates before heading into 2016, not because of the strength of the economy but because it wants to build room to cut rates in the future. At Newton, he says, the belief is the Fed is as likely to have to reverse policy in 2016 as it is to continue hiking.
While this may seem a pessimistic outlook, others also expressed doubts over the strength of the fundamental backdrop in the U.S. Chris Barris, managing director and global head of high yield at Alcentra, believes it to be somewhat unusual to see a rate hike when projected growth and earnings are weaker than they have been in previous rate hike cycles. “I believe the goal isn’t to tighten conditions but rather to return to normality. The Fed is using this opportunity to replenish its future options and going forward we believe it will watch inflation but also the health of corporate America.”
“The key is whether the Fed delivers on its promise to be slow, gradual and cautious. We need to see the global economy and markets take that pace in stride.”Jason Celente, Senior Portfolio Manager, Insight Investment
Barris is not the only one pointing out the potential concerns surrounding U.S. corporate profitability in the face of rising rates. Todd Wakefield, senior managing director and portfolio manager at The Boston Company Asset Management*, says two rate hikes, or 50bps, have been priced in by equity markets for next year but not four (100bps). He notes if equity investors expect four rate increases, they’d also be expecting the dollar to rise which would put pressure on corporate earnings at a time when there is arguably a recession in the manufacturing part of the economy. “If the Fed is still raising rates in the second half of 2016 and Europe and Japan are still loosening policy, I would expect the U.S. dollar to move even higher. In this scenario we would worry about a recession in corporate profits.”
Barris agrees that earnings will have to be a focus going forward: “Earnings have hit an air pocket recently partly due to the appreciating dollar. Some sectors such as commodities are experiencing cyclical softness and the Fed will watch to see if that softness spreads in coming months.”
Jason Celente, senior portfolio manager at Insight Investment, adds: “What’s important is that the Fed remains acutely aware of risks going too far. We’re not expecting a taper tantrum-like event or meaningfully wider credit spreads. The key is whether the Fed delivers on its promise to be slow, gradual and cautious. We need to see the global economy and markets take that pace in stride,” he adds.
On this theme, certain parallels have been drawn between fundamental conditions today and those ahead of the ‘bond massacre’ of 1994 when Alan Greenspan, then chair of the Fed, was deemed to have hiked rates too fast too soon.
Barris says this time is different. “The Fed took the market by surprise back then with an aggressive pace of successive increases. Given that volatility, high yield had slightly negative returns over those 12 months. Yields back then were similar to what they are today but spreads are far wider now than in 1994. Today the markets are significantly larger. In the U.S., they’re more diversified by sector and issuer. The investor base for the asset class is far more global and diverse. There is a European market today, which is benefiting from the accommodative ECB. “While there are similarities to 1994 in that central banks are diverging, the markets and the Fed are very different now and the global high yield investor has a far wider market to select from in order to benefit from this divergence.”
Referring to the divergence between the monetary policies of different global central banks, Raman Srivastava deputy CIO at Standish Mellon Asset Management*, says if it plays out like prior rate-rising cycles there could be a continued strengthening of the U.S. dollar. If this doesn’t happen it could put more pressure on global central banks to react. “I expect policy divergence to continue regardless and believe it’s supportive of global fixed income markets, especially if currency risk is hedged out.”
Another big question ahead of the Fed’s announcement centered on emerging markets and how assets in the region would respond given the large amount of dollar-denominated debt issued. Srivastava says over the past few years, EM debt has been a “shunned asset class”. Srivastava continues: “In 2016, we expect more of the same for fixed income markets; a slowing China, a slow global economy that limits inflation and limits rate rises. Barring a flight to quality event, we’re expecting muted returns, but we’re not forecasting large rate rises or negative returns.”
So the first move has come, but it is clear from here, Fed Chair Janet Yellen and her committee will be watched as closely as ever and will have to tread carefully in the coming year.
1 Financial Times: ‘Historic gamble for Yellen as Fed makes quarter point rise’, 17 December 2015
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