Many commentators have for a long time thought that interest rate hikes had been consigned to the pages of economic history. Yet the Federal Reserve, led by chairwoman Janet Yellen, has recently renewed hopes that some form of “normalised” monetary policy could be brought back to life by raising interest rates.
Twelve months on from the first rate hike in nearly a decade, the Federal Reserve announced that it will raise their benchmark interest rate by 0.25%, to a range between 0.5% to 0.75%.
Citing stronger economic growth and rising employment, Yellen argued that the rate hike should be “…understood as a reflection of the confidence we have in the progress the economy has made”. The Federal Reserve foresees three more rate rises in 2017, more than the market was expecting – but it must be remembered that there were four rate hikes forecast in 2016, and we’ve only seen one. Whether these will come to fruition remains to be seen. However, with Donald Trump heading to the White House, additional interest rate increases might be required due to the inflationary nature of his proposed economic policies.
Yellen chose to remain tight lipped on any questions surrounding President-elect Trump though, suggesting that it was important for the Federal Reserve to remain independent, and thus it was not her position to offer advice to the incoming President, nor was it right to speculate on Mr Trump’s economic strategy without more details.
The Federal Reserve is typically seen as the world’s puppet master in terms of co-ordinating monetary policy, whenever their policy changes on rates, other countries follow, none so much as the UK.
There once was a time when a rate rise in the US could have seen intense pressure for the UK to mirror their actions. However, as Theresa May pieces together the puzzle surrounding Britain’s exit from the European Union, the resulting uncertainty building up within the economy has ensured that the Bank of England is now on a very different path. Policymakers housed at Threadneedle Street are unlikely to be persuaded to change their plans as a result of the Federal Reserve’s announcement, especially since it has not come as any shock – markets had already priced in a rate hike.
Sterling
A rise in interest rates typically means that investors can get a better return on their investment and results in an inflow of funds to domestic assets. However, since the market had priced in the rate rise, with market participants acting on the assumption that it was a given, any further increase is likely to be muted. The value of Sterling has already fallen 14% vs the Dollar following the Brexit referendum, and is likely to see further intensified volatility as the Brexit negotiations start in earnest next year.
The market
As mentioned, investors have been operating on the premise of a US rate rise being reasonably assured, thus initial reactions in US equity markets, following the Federal Reserve’s decision, have been largely subdued. Banking stocks displayed the most significant gains, buoyed by the prospect of higher interest rates which tend to boost lending margins.
The Dollar strengthened against major currencies, including the Euro, Sterling and Yen. This could potentially boost share prices for companies which generate their profits in Dollars (there are many listed on the London Stock Market). A weaker Sterling also helps exporters, so companies with extensive exporting operations will also likely benefit.
Gold denominated in Dollars reacted badly to Yellen’s announcement falling by 1.3% since the previous day, as the opportunity cost of holding Gold increased.
US bonds, as would be expected, tumbled on the prospect of a faster pace to interest rate rises, due to the downward pressure an interest rate hike has on the value of their coupons.
Looking to the future, Emerging Markets could struggle, particularly those with debt denominated in Dollars, as repayments become more expensive. However, as has been alluded to, markets have priced in the rate rise, so the impact on such markets is likely to be muted?
Overall
The effects of the Federal Reserve have been subdued as many investors had already priced in an interest rate rise to their investment decisions.
However, 2017 does not look like it is going to be plain sailing, with many political time-bombs having the potential to severely rock the boat that is the world economy, suggesting a far more volatile period lies ahead.
Not everything needs to be gloomy though, the UK is set to embark on a new chapter in its history which may pay dividends and Quantum has just moved to a new office in Cardiff!
I would also take this opportunity to wish you all a Merry Christmas and a Happy New Year.
Ben Deidun
ben.deidun@quantumadvisory.co.uk