Interest rates finally rise in the US

16^th December 2015 - The US Federal Reserve (the ‘Fed’) has raised interest rates for the first time in nearly a decade. In a widely anticipated move, the Federal Open Market Committee (FOMC) voted unanimously to raise the cost of borrowing by 0.25%, ‘marking the end of an extraordinary seven-year period’ in the words of Janet Yellen, the Fed Chair.

Here is the initial reaction from a selection of market commentators:

Christopher Mahon, Director of Asset Allocation Research at Baring Asset Management:

"Rarely has a monetary policy decision been so anticipated by so many for so long.

"Expect the Fed to be watching the market's reaction closely. They are terrified of making a policy error, and will need time to assess how today's decision impacts both the real economy and the market. This means they are likely to proceed very slowly and cautiously.

"What we have seen today is not the Fed taking away the punchbowl but instead a very mild watering down of the liquor itself. But make no mistake: that liquor is still potent. The rates are still exceptionally low and monetary policy is still being set with a view to encourage growth, not rein growth in."

Stephanie Sutton, Investment Director - US Equities, Fidelity International:

“With the first rate rise now behind the market, the focus will turn to the pace of further increases. Whilst gradual rate rises have been priced in to the market, any acceleration in the pace might create uncertainty and volatility.

“Further, whilst the rise in itself acknowledges the good health of the US economy, it certainly increases the debt burden on both households and companies. Thankfully, there is little risk of payment shocks or greater defaults, as the bulk of household and non-financial corporate debt is in fixed rate loans. To illustrate, approximately 90% of US mortgage debt is locked into fixed rates and the modest increase will not have a major impact. Despite this, the two possible areas of concern include student debt and subprime auto loans as these have witnessed high delinquency rates rise in the recent past. However, increased delinquency in these two areas does not really threaten the financial stability of the economy. In addition, a strengthening economy and job growth will help debtors to service these loans.”

Edward Smith, Asset Allocation Strategist, Rathbones:

“Historically, global equity markets tend to do well for at least a year after the US sets off on a rate-rise cycle. Taking into account data going back to 1990, the best conditions for equity returns have been when interest rates are increasing and growth is rising.

“One of the most important drivers of equity returns is economic growth. The outlook for global growth is much less certain than the direction of US interest rates, and this is what investors should be focusing on. It should be marginally higher next year, but some of that is due to a less severe drag from the slowdown in China, and recessions in Russia and Brazil. We’re looking to a nascent recovery in the eurozone, and the long-awaited consumption effects of the oil plunge to also improve upon 2015’s growth rate. Finally, corporate cash piles have been growing over the past few years, as companies refuse to invest. Our research shows companies usually start returning capital about two months after the Fed raises rates. This may be driven by managers looking to put money to work before the cost of capital eclipses the potential returns. Those companies with the ability to grow dividends and continue to buy back shares could be rewarded by investors, while those that can’t may be found naked when the tide goes out.”

Woodford Investment Management:

Janet Yellen, Chair of the Fed, recently described the need for the rate hike as being “a testament… to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession”.

We would agree with this assessment, to an extent, but the operative word in that statement is perhaps ‘our’. The US economy has, by some distance, been the best performing developed economy in the post-crisis world and, in some respects, does appear to have ‘normalised’. But that statement needs to be viewed in the context of just how low interest rates have been and for how long. This is an unprecedented period of economic history and nobody is really sure what normal should look like!

Furthermore, there may be far-reaching consequences of the Fed’s decision to raise US interest rates. The US dollar is still the world’s reserve currency, and when the cost of the dollar rises, it has an impact on individuals, companies and sovereigns that hold dollar-denominated assets and liabilities.

Already, we have seen emerging market economies struggling with the tighter liquidity conditions that have prevailed since the Fed ended its programme of quantitative easing last year. The currencies of many of these emerging economies have been under significant pressure in this period and that looks set to continue. Indeed, conditions may worsen, particularly if these economies feel that their only response to the growing pressures in their domestic economies is to intentionally depreciate their currencies even further.

Nowhere is this more prominently the case than in China. Already we have seen China loosening its grip on the renminbi in the face of an economic slowdown that looks like a hard-landing with almost every macroeconomic data-point. US interest rate increases are likely to put more pressure on the renminbi and are likely to increase the Chinese authorities' desire to share their economic pain with the rest of the world through further currency depreciation.

Although an increase in US interest rates may be justified for the US economy, it is far from ideal for the rest of the world. The pace and extent of future rate increases is likely to be data-dependent, and it is plausible that the Fed will be cautious about hiking further in the next few months. But, in our view, tightening liquidity conditions already represent storm clouds for the global economic outlook.