'Lift off' - with a dovish US rate hike

21 December 2015

The US rate rise came as no surprise to us, as the US central bank’s chair Janet Yellen had broadcast for almost a year, to anybody who had cared to listen. Last Thursday Mrs Yellen announced that she and her colleagues of the Federal Open Market Committee (FOMC) had decided it was time to raise rates in the US by 0.25% (to 0.5%) - for the first time since the 2008 Financial Crisis and the Great Recession it caused; nearly a decade in total.

We were impressed how she and the US Fed delivered the rate rise announcement in a manner which left markets pretty much unmoved. What a contrast to the ECB announcement 2 weeks earlier!

As we commented last week, it was not so much the rate rise itself, which had become widely expected and accepted, but instead what she would say about the speed and timing of further rate rises over 2016 and thereafter. Around this point there had been a significant divergence between market expectations and the median expectation of the FOMC members as published through the so called dots plot (see chart on next page). Markets were and are still expecting a slower rate of interest rate rises than the rate setting committee.

In the end the revised December dots plot didn’t differ too much from those in September , but Yellen’s messages in the announcement and the press conference made it very clear that rates would rise more slowly and gradually than in previous rate rise cycles and in any case, unforeseen developments would always be taken into account. At the moment the Fed’s expectation is that in a years’ time US rates will be 1% higher than now, which would mean four rate rises of 0.25% each over the course of 2016. Markets currently only price in half as much.

It was a brave move, not because the US economy was not ready for it, but because markets once again offered plenty of opportunity to expect the worst. At the beginning of the week the risk asset sell-off of last week accelerated, when the oil price fell another -5% down to a mid US$30/b level. More junk bond funds in the US suspended further redemptions, following massive outflows from this asset class overall.

Both market events lead to a tightening in liquidity, which therefore makes central bank monetary tightening through a rate rise less digestible. The Fed and chair Yellen saw through this. When challenged during the press conference, they stated that the oil price effect was likely to continue to prove transitory and the high yield junk bond market sell off had no likely repercussions for the broader banking and financial markets, particularly after value seeking investors had started to buy up heavily discounted issues since Monday.

This and other ‘bottom fishing’ investor behaviour led to a short but sharp recovery rally in equity and other risk asset markets ahead and just after the Fed announcement. This gave some hope that a 2015 Santa Rally had arrived at last.

Such hopes proved short lived as the realisation took hold that US monetary tightening would keep upwards pressure on the US$, which in turn will keep commodity prices under downward pressure. At the time of writing, equity markets have stopped their ascent and appear to be consolidating their short term gains.

We are relieved, that the ‘waiting for Godot’ like market uncertainty around the timing of the first US rate rise is over and has not caused another big bout of market volatility. At the same time the issues around the end of the commodity super cycle (see last week’s Comment) and the flagging growth in the developing world have not gone away.

This means that until such time as markets observe a persistency of strengthening economic growth data points and the slowdown in manufacturing feeds through to higher company result expectations, the volatile sideways movement of capital markets is likely to continue for a while longer.

For the time between now and the end of the year, we hope for benign, up trending markets which would help to keep our clients 2015 investment portfolio returns closer to a mid-single digit percentage range – a result which would render 2015 an unexciting but not entirely disappointing investment year vintage.