As expected, the US Federal Reserve (Fed) lifted its benchmark target rate by a quarter point to a range of 0.5% and 0.75%, and raised its 2017 rate hike projections to 3, from 2 in September, on the back of strong economic data. The hike widens the already expanding gap between the US and the rest of the world, opening up a new set of opportunities that active managers can explore.
Please see below insights from the Legg Mason and its Affiliate managers:
Western Asset – John Bellows, portfolio manager / research analyst: “The more interesting parts of today’s meeting came in the FOMC’s forward-looking assessment. The FOMC did not materially change its growth forecast, even though the market appears to have reassessed the outlook significantly since the election. The FOMC likely decided it was premature to make any meaningful changes to its forecasts for 2017 or beyond. For a group of careful, empirically oriented economists, there is too much uncertainty on the size, scope and specifics of the new administration’s fiscal policies, not to mention what those policies may mean for growth. There are real concerns about tighter trade policy affecting demand and risk sentiment. Finally, the FOMC is well aware of just how hard it is to generate a pickup in growth. The struggle of countries around the world to find a successful policy mix that leads to faster growth highlights this point.”
Brandywine Global – Jack McIntyre, portfolio manager: “In terms of how the decision will impact the U.S. economy, we think it will depend on how the dollar reacts to the Fed. At this point, the third potential rate hike is now driving the greenback higher against all currencies. This has been the trend after Trump’s victory and it is tightening for the Fed well above today’s 25 basis points increase in the fed funds rate. A strong dollar may not in the best interests of the U.S. economy but bond investors might like it as the dollar will put downward pressure on economic growth and inflation.”
What was the market initial reaction? Equities fell as investors started pricing in the higher financing costs, while government bonds sold off, as bond prices move inversely to interest rates. Two-year US Treasuries, especially sensitive to Fed moves, spiked as much as 8 basis points to 1.25%, the highest since 2009. The US dollar soared to its highest level since 2003, something which could hurt countries with substantial amounts of US dollar-denominated debt, such as Brazil and Russia: the real fell c. 1% against the greenback, while the ruble dropped 2.2%. The Russian currency was also hit by a drop in oil prices: a stronger US dollar usually dents demand for dollar-denominated commodities, as it makes them more expensive. Oil plunged 4% to US$50 per barrel. Gold, often considered an inflation hedge, shed 1.2% as higher rates aim to rein inflation. The US 10-year breakeven rate, or the difference between nominal and inflation-adjusted real rates, edged lower. And so did the yen, down 1.6% against the greenback, as US securities become more attractive relative to Japan’s government debt, which mostly offers negative yields. The euro was down almost 1%, for the same reason. The cost to protect US corporate debt against default also rose, given the higher interest rates. Initial reactions may change as, while the Fed’s rate hike projections for 2017 were lifted, those for 2018 remained unchanged at 3.
Why does this hike matter? A US rate hike affects the entire world – through US Treasury (UST) yields, which as the world’s traditional “risk free” benchmark represent a floor for other US dollar-denominated debt yields – and through the US dollar, whose value is enhanced when higher rates attract capital from the rest of the world. Potential impact of the Fed’s move include: revaluation of fixed income debt based on new US Treasury yields; European, Chinese and Japanese exports may become more competitive as currencies weaken; downward pressure on commodity prices; pressure on non-US debt denominated in US dollars, and higher corporate financing costs. These are sheer changes which, combined with the present negative rates in Europe and Japan, may create opportunity for active managers.
Is the Fed now more aligned with markets? Yes: for years, the Fed has been overestimating its growth, unemployment and inflation projections, amid slow domestic growth and international headwinds. In 2016, the Fed has cut its own projections, while the market has increased its own, especially after Donald Trump’s US election victory. As seen in the chart, the two are now aligned.
Finally catching up: Fed and market rate expectations
The Fed VS. The World
The Fed has been scaling a wall of global challenges in its quest to return to more normal monetary policy. Previous Fed chairman Ben Bernanke’s hint in 2013 that the central bank planned to taper its stimulus sent yields soaring. Since then, repeated European crises, persistent low inflation, a shock Chinese devaluation, geopolitical tensions, the collapse of oil prices and last, Brexit, all refrained the Fed from raising rates more than once (in December last year). Now, more than 3 years after Bernanke’s first warning that rates should be more in tune with the real state of the economy, the Fed seems to be finally getting its way.
Another hike bites the gap
What are the effects of rising rates on equities?
The rate hike seems to have confirmed what US equity markets have been signalling for several weeks: rising expectations for better economic growth in the months ahead.
Dividend stocks can still play an important role in your portfolio – a rising rate environment should not be viewed as a reason to shun income-generating equities.
What are the effects of rising rates on fixed income?
Is the US economy strong enough to bear a rising rate cycle?
Interest rates normally reflect the state of an economy. However, since the global financial crisis, interest rates around the world have been abnormally low (or even negative, in the case of Europe and Japan) as central banks have gone to great lengths to kick-start global growth. Now, as economies start to pick up, central banks want to normalise their policies by hiking rates to a level that better reflects real economic growth. But, is the US economy ready for a rising rate cycle? Is the recent risk rally and government bond sell-off justified by real economic prospects?
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