US interest rate rise 2015: What will a Fed hike mean for global markets?
The US Federal Reserve, after months of speculation, will announce on Thursday whether or not it is to raise its benchmark interest rate for the first time in nine years.
Experts have questioned whether the US, and the world, is ready. Even the IMF has called for a delay.
Unemployment in the States may have fallen to 5.1 per cent and second quarter growth has been revised upwards to an annualised 3.7 per cent.
But inflation lags way behind the Fed’s two per cent target (at 0.3 per cent), and wage growth is also poor.
Read more: This is no Doomsday for emerging markets
To make the Federal Open Markets Committee’s (FOMC) decision even harder, the Bank for International Settlements warned this weekend of “a bifurcation in global liquidity” which will weigh particularly on emerging markets if the Fed calls time on cheap money.
Whether it comes on Thursday or not, a Fed rate hike is coming. So what will it mean for markets?
BONDS
Higher interest rates are expected to drive up demand for US fixed income securities, but the adjustment in bond prices will be very gradual.
Most economists expect the Fed to hold off until at least December. But any initial increase, whenever it comes, is unlikely to exceed 0.25 percentage points, taking the Fed funds rate to 0.25 – 0.5 per cent.
As Simon French, chief economist at Panmure Gordon, explains, the sell-off in government and corporate debt must be “tempered against the ongoing appetite for safe haven assets and concerns over the valuations of alternative investment classes, such as equities and commodities.”
US Treasury bonds will be the ones to watch on Thursday, says FxPro’s Angus Campbell.
“They have been acting very much as if no action will be taken when the FOMC decision is announced. But if they do move with a hike, investors should expect a decline, particularly in shorter-dated US Treasuries.”
On this side of the pond, a sell-off in UK gilt-edged securities is likely to occur, Campbell argues, because the Bank of England is expected to follow the Fed in 2016.
EQUITIES
In the US, an equity bull market has prevailed over the last few years. A flow of liquidity and bumper earnings growth has been achieved through aggressive cost-cutting and easy refinancing, says Jason Hollands, managing director at BestInvest.
Equities prices have increased and US companies have borrowed significantly to buy their own shares back. As borrowing becomes more expensive, “corporates are going to have to deliver more top line sales growth to justify current ratings”, says Hollands.
The extent of equity market volatility will depend on how the rise is interpreted, argues French.
“If it is seen as a forebearer of a significant tightening cycle then this will remove some of the froth in equities which has resulted from the ‘hunt for yield’.”
Equities have sputtered with speculation of a rate rise, and a clear announcement on Thursday may provide relief for investors.
If the move is just 0.25 percentage points, stocks may fall slightly over the days which follow, says Campbell, but any greater decline in stocks would be unprecedented. This is largely because the move is thought to be one of a number of small increases. Anything more significant would be cause for concern.
COMMODITIES AND EMERGING MARKETS
With the commodities supercycle over, markets are struggling to get rid of their surpluses. Companies in the industry with large amounts of debt, like mining giant Glencore, are really feeling the pain. A rate hike will make things more painful.
Commodities denominated in dollars will become more expensive for foreign buyers, so demand may weaken as the dollar borrowing becomes more expensive to service.
Gold and precious metals will be hit hard, says Augustin Eden, research analyst at Accendo Markets. But demand for basic materials used in construction and infrastructure may prove more resilient.
The outlook for commodities has looked bleak as Chinese demand has started to subside, and the commodities rout has been cited as reason for a delay.
Indeed, Chinese demand is perhaps a more pressing concern for commodities investors than more expensive debt.
Julian Jessop, chief economist at Capital Economics, points out that commodities (and emerging markets) “tantrumed” in May 2013 in the lead up to the Fed’s decision to scale back its bond purchases.
However, they picked up again in 2014, once the “tapering” had actually started. Chinese growth picked up slightly in August (6.1 per cent year-on-year), and Jessop predicts it may strengthen further before the end of the year.
Higher interest rates may put pressure on commodity producers to cut their output, which should prove supportive for prices, says French.
“However, it is a slow process and the downward bias will certainly remain, whatever the decision this week.”
Emerging markets, particularly major commodity exporters, are in for a tough time. Demand for Brazil’s commodities has tailed off in the wake of the Chinese slowdown.
And last week, the real fell to a 13-year low against the dollar and Standard & Poor’s decided to “junk” its credit rating.
After a hike, the dollar debt market will demand higher yields, and countries looking to rollover debt which is already appreciating against their domestic currency will be subject to higher reissuance costs, explains French.
There is little wonder, says Eden, that central bankers in emerging markets are urging the Fed to get on with it.