The Fed sees Green
“After seven years of holding rates at effectively zero, the Fed has now lifted its target range for the Fed funds rate by 25 basis points”
Finally, all the members of the Federal Reserve Bank have unanimously agreed to raise interest rates for the first time since 2006 stressing that future interest rate rises will be gradual. Clearly, in their Fed statement, and minds, they now believe that the current resilience of the US economy justifies this decision and supports the notion that a gradual rate hike environment will not harm the wider economy.
Indeed, after seven years of holding rates at effectively zero, the Fed has now lifted its target range for the Fed funds rate by 25 basis points [bp] to 25-50bps, even though headline inflation is currently below its 2 per cent target. Understandably, much of the downward pressure on inflation has come from the collapse in energy and import prices and like Fed chair, Janet Yellen, said in her statement “keeping interest rates near zero for much longer would have created an undesirable risk that inflation would eventually overshoot the target, thereby forcing the Fed into more aggressive destabilising policy tightening later on”.
“It would appear that this decision by the central bank was judged as a success by Wall Street”
Understandably, market watchers kept one eye on Ms Yellen as she delivered the Feds reasoning with the other on the stock market and asset price movements, and of course, it would appear that this decision by the central bank was judged as a success by Wall Street as the market closed up by a meaningful amount whilst the US dollar gained some upward momentum against a basket of leading currencies.
Unquestionably, the Fed will remain data dependent over the coming 12 months but already the market is pricing in at least two further interest rate hikes in 2016, and history would tell us that the Fed will want to see the rate above 1 per cent over that timeframe. Indeed, looking out beyond 2017 the projections are for US interest rates to breach the 2 per cent level.
“We will need to be mindful of the ramifications that might have for the treasury and currency markets”
Given that the Fed has now pulled the interest rate trigger we will need to be mindful of the ramifications that might have for the treasury and currency markets. Firstly, it is widely anticipated that yields on government paper will begin to back up from their current levels and that the US dollar will appreciate, given that the European Central Bank, Bank of Japan and the Peoples Bank of China will be retaining their loose monetary policies and quantitative easing programmes for some time to come.
With this mind, some investors have become fearful that the US dollar will strengthen aggressively, similar to what happened in the 1990’s which led to an emerging market currency crisis, indeed, we have already experienced a sequence of “currency wars” this year with the most recent being the announcement by the PBOC that they have launched a new index to monitor the movement of the renminbi against other leading currencies, which follows the recent devaluation of their currency.
“The Chinese authorities are not enamoured by the Federal Reserve Banks monetary policy and are showing signs that they want to unpeg themselves from the US dollar”
This clearly shows that the Chinese authorities are not enamoured by the Federal Reserve Banks monetary policy and are showing signs that they want to unpeg themselves from the US dollar, this in turn, could lead to other central banks within the developing world trying similar strategies to try and weaken their currencies making them more competitive.
However, expectation are that the US dollar might strengthen at a modest pace in 2016 followed by rising inflationary pressures and a flattening US yield curve which will eventually see the dollar decline as growth in real yield disparities turn negative.
Therefore, if we were to summarise then we would suggest that the world is on track for modest economic growth in 2016, as central banks diverge. The Fed will continue to tighten, ultimately followed by the UK, and currencies will remain an important component of any future investment returns. Finally, whilst this week’s US interest rate hike was staggeringly small it does represent a big change in monetary policy, with the possibly that we have entered a “new era” after a decade of zero interest rates and cheap money.
Peter Lowman, Chief Investment Officer
Peter Lowman has been in investment management for over forty years and prior to becoming Chief Investment Officer for Investment Quorum, he worked within a larger asset managers, primarily as an Investment Director with Cazenove’s. He is responsible for the overall investment strategy for Investment Quorum clients and sits on the Investment Quorum Committee.
This article does not constitute specific advice and investors should bear in mind capital invested is not guaranteed.
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