The most telegraphed Fed-engineered rate rise in history is over. The Federal Reserve Open Market Committee (FOMC) raised short term rates a quarter of a percentage point at its meeting Wednesday afternoon. The markets largely took the news in stride, which was exactly what the Fed desired.
Nevertheless, they set rather cloudy expectations about what they’ll do next, saying “the stance of monetary policy remains accommodative” and telling us that any further increases would be gradual. So, what happens next? We think there are a few places to look for direction.
The first is politics, which we see as raising the stakes. With the U.S. now in the midst of a prolonged election season, we have noticed that economic and market events have a touch more than the usual political overtones. We believe this may elevate the risks, as the media, which loves to present audiences with good entertainment, exacerbates polarized political arguments. Overall, there’s nothing new there, but in totality political rhetoric could increase market volatility.
In addition, the drop in commodity prices is reeling through the system. While there are certainly bound to be winners and losers, the theoretical winners are not yet appearing to the extent that the steep drop in the price of oil might imply. Consumers have bought cars, but other gains from oil price falls are less prominent. Instead, is it possible the disruptions may indicate that the U.S. economy is not quite on the solid ground that accompanies most upward moves in interest rates? Typically, the last thing that businesses, investors, and money managers want is uncertainty. If economic activity is on an upward trend, great, but if the economy stumbles and the Fed is forced to make a U-turn, we think it will likely not be pretty for investors.
High yield bonds have seen significant pressure in the last two weeks, accelerating the price declines already witnessed this year. Equity markets have also been volatile. This makes for a quick reality check on the Fed policy; do markets agree with the Fed and think the economy is stronger? Given wider credit spreads, the cost of capital had already climbed before the Fed tightened. The implication is that the Fed may not need to do much further tightening as a means of altering conditions. A rising rate environment typically aligns with improvement in credit quality and a narrowing of credit spreads, but that is not what we are seeing. We believe this paradox deserves greater scrutiny.
The U.S. dollar, by appreciating, has priced in expectations of higher rates in the U.S. Its fate, too, is based on continuing strength of the U.S. economy in 2016 as well as the future path of interest rates.
The rest of the world is on a different path, with monetary accommodation still increasing. Bleak growth prospects and dwindling price pressures have set expectations that other central banks will not be following the Fed. More likely, we anticipate quantitative easing (QE) continues in Europe and Asia. In Europe, the front end of many yield curves show negative interest rates, exhibiting how the QE process has destroyed the mechanism that values bonds.
With the Fed's decision to hike rates and end the interminably long era of zero interest rates, markets have entered a new phase and are now likely to begin an iterative process with the Fed, setting expectations for the path forward. We believe this could engender a period of heightened volatility for investors. While the Fed’s self-described gradual pace leaves us with the sense that they will do nothing soon, we also have little sense of what event (inflation rumblings, perhaps?) might cause them to take their next step. In sum, things are just getting interesting.
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