What to do when you're expecting
05 October, 2015
Hollywood movies make pregnancy seem easy with 4am ice-cream and gherkin cravings seemingly the only challenge to overcome. But any parent will tell you that the waiting is often the hardest part. You know what's going to happen at the end of nine months, but the end seems to take forever to come.
Markets have been pregnant with expectation over the next Federal Reserve interest rate hike. The lead up to the Fed's September meeting was nerve-wracking with the "will they, won't they?" speculation leading to increased market volatility. Investors were left unsatisfied when a rate hike didn't emerge, because it means a nervous wait for another month or two. We know that the Fed will lift interest rates at some point, but now we don't know whether it will be at their October meeting, December meeting or pushed out into the New Year. And so we wait.
Knowing what to expect might help, especially when investors realise that actually, not much is going to change. When the Fed eventually raises rates, there might be an immediate and short-lived reaction in share markets and short-term interest rates, but because rates will likely be lifted only a small amount — we're talking 0% lifting to 0.25% — there is unlikely to be a significant or long-lasting impact.
For those who need proof, analysis completed by equity strategist Bob Doll confirmed that over the past 35 years, the US market is most often up sharply heading into a rate hike, fairly flat in the 250 days after (average gain of 2.6%), then back to normal once 500 days have passed, with an average return in the past six cycles of 14.4% following hikes.
As far as individual companies are concerned, we know that not all companies will be affected by an interest rate hike. Clearly those that are the most leveraged (i.e. have the most debt) will be most adversely affected by increased interest rates as their cost of borrowing will increase.
As for GDP, according to Deutsche Bank, in past cycles interest rates have generally been hiked when the economy was running hot, so GDP has slowed after the lift. This time around, the US economy is experiencing a relatively slow recovery from a particularly bad recession so the GDP impact might well be positive rather than negative. GDP seems to have the most positive response to an increase in interest rates when the economy is strong enough, but not too strong. The Fed has been hesitant to wait until all the signals point to a strong enough economy, so this should be one of the good cycles.
As for bonds, it is more likely to be the yield curve, or the gap between short-term bond yields and long-term bond yields that is affected rather than the yields on all bonds. Short-term interest rates will react more than long-term interest rates, but it is important to remember that short-term interest rates don't have a significant impact on the economy or the availability of credit. As for longer-term interest rates, they reflect long term expectations of economic growth and inflation, so an eventual rate rise will very likely be priced in to long-term bond yields already.
When the Fed eventually moves, it really isn't going to matter anywhere near as much as the media suggests. Even though every word the Fed utters between now and then will be analysed backwards and frontwards, it's all going to be okay in the end. We are in the camp that just wants it done... Let's get this baby out and get on with it! Unfortunately we have another month or three to wait. Ice cream and gherkins anyone?