What the Fed rate hike means for investors
Market wasn't surprised at all.
BY Staff | December 17, 2015
Yesterday’s 25-basis-point rate hike by the U.S. Federal Reserve’s didn’t surprise markets. What did was how many hikes are expected to occur in 2016 and 2017, says Prab Sagoo, associate director at Nasdaq Advisory Services.
“The calculations from the dot-plot that the Federal Reserve put out indicate there may be up to four rate hikes by the end of 2016,” he notes. “I don’t think the market is pricing in that many hikes, so there’s a little bit of a disconnect as we go into the next two years.”
But, he adds, “The Fed is going to keep an eye on how the economy, labour market and inflation develop. Previously, the market had been worried that the Fed may embark on a persistent rate-hike cycle, whereby every meeting or two [it] might hike rates. However, with what’s been said so far, the [central bank] seems very dependent on data.”
And there’s good reason for that, says Jeff Waldman, head of Global Fixed Income at CIBC Asset Management. “Since 2006, when the Fed last hiked rates, total U.S. debt has increased $20 trillion, but the size of the economy has only increased $4 trillion. So it will take fewer increases this cycle to impact growth. Once the Fed realizes that hiking is having a negative impact, that will signal that the Fed’s tightening will have run its course.”
Impact on equities and bonds
The rate hike, in and of itself, is no game changer for equity markets, says Robert Spector, portfolio manager, MFS Investment Management in Toronto.
Markets had priced in Yellen’s move, “which was clearly telegraphed well in advance.” And Fed policy is still extraordinarily accommodative, Spector emphasizes. The Fed funds rate is “well below what anyone would expect in the context of an economic expansion that started seven years ago.”
The move should not be viewed as a headwind for equities. “The equity outlook is going to be determined by many more things besides the Fed. You have commodity prices, the earnings outlook, company-specific issues, growth in China, and so many other issues. These things are not going to immediately shift based on one hike.”
Currently, we’re seeing minimal impact on North American equity markets, says Sagoo. “There was a little volatility directly after the announcement, but most of that was just [people] trading positions rather than fundamental movements. For the most part, it’s stable on the equity side, with strength building up only fractionally. We have seen some sharp rises in equity markets over the last two days, though, with the TSX up about 2.5%, so we have seen some strong gains and we’re adding to that.”
The TSX Composite closed up 1.91% and the S&P 500 closed up 1.45%.
Yesterday was a particularly good day for income-oriented sectors such as utilities, real estate and telecommunications. “These sectors are sensitive to rate increases and are often impacted negatively. But we’re seeing strong performances. Utilities tend to underperform heading into rate-hike cycles. However, given the slow schedule that Janet Yellen has indicated, utilities are getting a good bid due to too much negativity being priced into the sector.”
Financials are also benefitting, says Sagoo. “It’s good for them to have higher base interest rates so they can borrow at cheaper rates and then lend at higher rates further along the curve. [So] we will continue to see banks benefit in the future, if we go along a gradual rate-hike cycle. Also, as every rate hike occurs, banks should benefit.”
When it comes to bonds, the rate hike was expected. “But, if you look at the yield of government bonds, the yields for five-, 10- and 30-year U.S. Treasurys were dropping dramatically after the announcement. The market had forecasted that maybe it would be a little bit aggressive of a rate hike cycle, but the [Fed’s] release and comments were more dovish. So yield fell and prices rose on both the U.S. and Canadian side. They’re coming back up but there was initial weakness.”
Impact on loonie and USD
The rate announcement could play a role in potential currency movements, says Spector. Though the U.S. dollar has risen for the better part of a year and a half, the monetary policy divergence between the Fed and other countries, combined with stronger growth in the U.S., suggests the greenback “will still have this upward bias.”
For now, the loonie is holding steady against the U.S. dollar, says Sagoo. “We’ve just seen a bit of a pullback because of big traders starting to react on the foreign exchange side to the announcement that the rate-hike cycle may be slower than expected.”
And “there could be further weakness in the Canadian dollar, at least in the near term. If we see any type of consistent uptick in underlying inflation in the U.S., the loonie could [fall] further.”
For its part, the BoC will wait for more strength in exports before tightening, says Sagoo. “It will need to ensure that the positive effects of a stronger U.S. economy are countering the persistently weak energy sector.”
Spector says continued U.S.-dollar strength means “Canadian investors will have to continue to look globally and to the U.S. for opportunities.” On the fixed-income side, Spector emphasizes U.S. corporate bonds, “which in a world where policy is still accommodative, the U.S. economy is growing, and the recent rise in credit spreads, present a unique opportunity for investors.” He adds that market has industry diversification opportunities we lack in Canada.
Expect equities to continue to outperform bonds, and particularly government bonds, adds Spector. He’s also emphasizing non-Canadian versus Canadian equities.
Given how small the rate increase was, combined with Yellen’s emphasis on the gradual nature of further hikes, Spector says there aren’t any sectors that will benefit specifically from yesterday’s news.
However, Sagoo notes, “A lot of the opportunities will be with companies that have revenue tied to U.S. growth. If you have revenue denominated in U.S. dollars, you’ll see a positive tailwind for [these] companies’ earnings. But, of course, this is dependent on how the U.S. economy performs. This is a small, token rate hike.”
U.S. earnings landscape has been anemic lately, he adds, so this doesn’t guarantee investors will see any opportunities in the short term.
But, says Waldman, global divergence of central bank policies will remain. Investors can also consider the stances of the European Central Bank and Bank of Japan as they consider investment strategies going forward.