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Lift-off, as scheduled

17 December 2015

The Fed’s first rate rise in nine years was well-received by markets, and represented a more upbeat assessment of the health of the US economy.

Former Federal Reserve Chairman, Ben Bernanke, said earlier this year that “boring is good in financial markets”.

This week his successor, Janet Yellen, sought to prove that mantra true, delivering exactly the US interest rate policy that markets were expecting: a hike of 0.25%. Even though it was the first Fed rate rise in nine years, markets did not appear ruffled, testament to how effectively Yellen had communicated her intentions in advance. Markets do not like surprises from central bankers.

Moreover, all 12 voting members of the Federal Open Market Committee – the group that makes rate decisions – voted in favour of the hike. Unanimity offers some level of reassurance to markets both that the decision was the right one, and that the Fed will be suitably predictable in future.

“The committee’s decision being unanimous is a positive and, on balance, we think the Fed got things right,” said Gary Kirk of TwentyFour Asset Management. “An insurance policy against future inflation, set against the ability to do more should economic data disappoint, is what the market wanted to hear.”

The rate hike was “largely symbolic” according to Jim Henderson of Aristotle Capital Management. “Over the past several years, the Fed has travelled down the path of openness and transparency, aiming to foreshadow future moves so as to not roil markets.”

In her press conference on Wednesday, Janet Yellen validated the rate rise by pointing to “the progress…made toward restoring jobs, raising incomes, and easing the economic hardship of millions of Americans”. She also expressed confidence that the US economy “will continue to strengthen”; it grew 2.1% (annualised) in the third quarter.

“The US economic backdrop is positive, but far from strong, and so a move away from very low interest rates to something more normal may be taken as a vote of confidence in the US economy and therefore as a positive development,” said Luke Chappell of Blackrock.

Concerns about the strength of the US economic recovery remain at large, but markets appear comfortable that they are manageable. While US inflation remains far below the Federal Reserve’s target of just under 2%, Yellen also explained that rates policy tends to have a nine-month time lag. She also highlighted the impact of the falling oil price. “We do not need to see oil prices rebound to higher levels in order for the impact on inflation to wash out,” Yellen told press on Wednesday. “All they need to do is stabilise.”

Perhaps more important still was her reminder that “even after this increase, monetary policy remains accommodative”. A rise to 0.25%-0.5% still leaves rates low by historical standards – indeed, the Federal Reserve has not so much slammed on the brakes as taken its foot off the gas pedal. Instead, the move is perhaps most important for what it says about the US economy, rather than for any decisive impact it will exert.

“The fact that the Fed believes interest rates should rise underscores that the US economy has made good progress since the onset of the Great Recession,” said Tye Bousada of Edgepoint. “Despite the historic nature of the rate increase, it’s important to put the hike in perspective. It is hard to envision a scenario where a 25-basis point rate hike affects the runway for growth, or the investment opportunities of most companies.”

Perhaps the most important issues addressed in the press conference was the longer-term rates outlook. Janet Yellen pointed to a “gradual” tightening to come, but left the Fed latitude to respond to economic changes. As part of its policy decision, the Federal Reserve released its ‘dot plot’, which provides an expected trajectory for future rates.

“With the Fed funds rate now on an upward trajectory, we have a better sense of what a “gradual” pace of rate hikes means,” said Brad Boyd of Payden & Rygel. “According to the ‘dot plot’, the Fed funds rate should be between 1.25% and 1.5% in December 2016. So gradualism would equal four rate rises in 2016 – albeit dependent on economic data.”

Yet, while the December rate rise was widely expected on markets, the Fed’s longer-term outlook – together with its plans for 2016 – diverges somewhat from market expectations.

“The Fed’s expectations of 2.4% GDP growth and 1.6% inflation in 2016 are apparently far more bullish than the bond markets expect,” said Boyd. “Indeed, there is still disagreement in terms of the level of overnight rates in 2016 and beyond. The market has two hikes priced in, the Fed rate implies four hikes. We think investors may have to begrudgingly expect that Fed funds are moving higher.”

Equity fuel?

Equity markets around the world responded positively after the decision was announced.  

“The rise is good for equities, both from the perspective of getting it out of the way, but also in the sense that there won’t be substantial further increases any time soon,” said Chris Ralph, chief investment officer at St. James’s Place. “Yellen was pushing them out well into 2016, which was encouraging.”

Moreover, equities have tended to perform strongly in the year following an initial interest rate rise. In part, this is linked to those same positive economic fundamentals that allowed for interest rate rises in the first place – as economies grow, so too do companies.

Between 1975 and 2015, the US Federal Reserve has introduced seven interest rate ‘lift-offs’; in five of the seven cases, the S&P 500 was higher twelve months after lift-off, averaging a return of 3.4%. In the UK, where there have been nine interest-rate ‘lift-offs’ carried out by the Bank of England over the same period, the story is even more decisive. In every case, the FTSE All-Share index rose in the 12 months after the initial rise, on average by 17.9%.*.

How the US equity market performed historically in the year after previous Federal Reserve lift-offs

*Source: Schroders, 17/12/15. Please be aware that past performance is not indicative of future performance. The value of an investment may fall as well as rise. Returns on equities are not guaranteed.

History seems to counter the general perception that when policymakers embark on a period of monetary tightening, equity markets struggle.

“In the UK, the Fed’s move is unlikely to force the hand of the MPC,” observed Richard Peirson of AXA Framlington. “There are other issues here, such as Brexit, which might influence policy, but a rate rise in 2016 still looks likely. Again, this should come as no surprise to markets.”

In the case of bonds, the impact of interest rates is more nuanced. A small rise of 25 basis points will have only a negligible impact, whereas expectations of more rises to come can lead some bondholders to sell. Polina Kurdyavko of BlueBay Asset Management commented, “The market was largely priced for this outcome. As such, the market reaction was somewhat muted, with no meaningful directional move. Spreads are a touch tighter and bond prices marginally up, but for the most part, this has been as close to a non-event as we could have wished for.”

That would explain why high yield credit markets did not show a strong reaction to yesterday’s news. It also serves as a reminder that short-termism on markets rarely pays dividends. As always, the key for investors is to look through such ‘market noise’.

“It’s crucial to remain focused on the longer-term, and not to be swayed by short-term market news items,” said Chris Ralph. “You need to be sure your portfolios are adequately diversified across different assets and fund managers, and to ensure there are different levers that can be pulled at different points.”

 

The opinions expressed are those of the investment managers and are subject to market or economic changes. This material is for information only and is not a recommendation or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

FTSE International Limited (“FTSE”) © FTSE 2015. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

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