The prospect of higher interest rates in the US is no longer something that investors should be overly concerned about, according to macroeconomic forecasting consultancy Capital Economics, which argues that equities could even rise when the first hike is finally announced.
The Fed’s rate-setting Federal Open Market Committee will next meet on 15 and 16 December, with many market commentators expecting the central bank to make its first interest rate rise since the global financial crisis.
Indeed, Capital Economics senior global economist Andrew Kenningham says this outcome appears to be “all but certain” following the recent publication of the US Employment Situation report, which showed a better-than expected 211,000 jobs were created in the world’s largest economy last month. Financial markets are now pricing in an 80 per cent chance of a rate rise at the next meeting.
Past years have seen investors fret about the prospect of higher interest rates, but more recently they have started to see the bright side – such as a rate rise indicating that the US economy is now in rude health. Kenningham says the disappointment prompted by the Fed’s inaction at its last policy meeting suggests markets could rise if the bank does move next week.
Performance of indices over 2015
Source: FE Analytics
“Given that the markets reacted adversely when the Fed decided not to raise rates in September, they may react positively if it hikes rates next week,” the economist explained.
“For a start, this would end the uncertainty over when the ‘lift-off’ will occur. It would also be seen as a vote of confidence in both the US and the global economies, particularly given that the decision not to raise rates in September was partly due to concerns about China. And provided the accompanying rhetoric is dovish, which we think it will be, investors should be reassured that any future rate rises will be gradual.”
One concern surrounding higher US interest rates is that this could choke off the economic recovery in other parts of the world. However, Kenningham also argues this isn’t necessarily the case and offers five reasons why investors shouldn’t panic if the Fed acts.
The US economy will be strong
“Assuming inflation remains low, Fed hikes would be conditional on the US economy continuing to do well,” Kenningham said. “A steady US recovery should, in turn, help many other economies by sustaining demand for their exports and supporting confidence.”
The US economy grew by an annualised 2.1 per cent in the third quarter of 2015, according to data from the Bureau of Economic Analysis. This was an upward revision on an earlier estimate, after investment and house building was stronger than initially estimated.
The latest forecast from the International Monetary Fund tips the US to grow by 2.6 per cent over the course of 2015, making it one of the brightest lights of the global economy, before accelerating to 2.8 per cent by the end of the following year.
Emerging markets are stronger than you think
Investors have worried over recent years about the health of the Chinese economy – which is the world’s second largest – after slowing growth rates prompted fears of a ‘hard landing’. These have been supported by weak data, including recent numbers showing a 6.8 per cent fall in exports in November.
“We don’t think November’s trade data was as bad as it looked. Import growth surprised on the upside and we think it will pick up further in the coming months as policy support takes hold,” Kenningham said.
“What’s more, other emerging economies are not as vulnerable to tighter US monetary policy as they were in the past, because they mostly have stronger balance sheets and floating exchange rates.”
Capital Economics does concede that many emerging markets remain vulnerable to the slowdown in China and lower commodity prices, but it expects that both of these situations will start to improve in 2016 and alleviate the pressure.
Other central banks will stay loose
While the Fed would surprise if it failed to lift rates again, Capital Economics expects the Fed funds rate to be no higher than 2 per cent by the end of 2016 and little over 3 per cent by 2017’s close – which is far below the historical average of close to 6 per cent since 1971.
Kenningham added: “Few other major central banks are likely to raise rates except the Bank of England, which should do so more gradually than the Fed. Indeed, several other central banks will loosen policy further.”
Last week, the European Central Bank eased its policy by less than expected, which disappointed markets, but the economist says this means it might simply be forced to increase the pace of its monthly asset purchases in 2016. Furthermore, the Bank of Japan is likely to step up its quantitative easing programme at some point, following renewed economic weakness.
Easing could also come from the People’s Bank of China, which has the option of lowering interest rates and reserve requirement ratios further. The bank has already made a number of moves in response to the slowing economy.
Strong dollar helping other economies
One of the main stories in markets over recent years has been the relative strength of the US dollar, which has surged on the back of economic strength and the prospect of higher interest rates. The below graph shows how sterling, the euro and the yen have weakened against the dollar over the past two years.
Performance of currencies vs the dollar over 2yrs
Source: FE Analytics
While this strength has acted as a headwind for the US economy by making its exports more expensive to foreign buyers, Kenningham points out that it has allowed other countries to sell to the US consumer more cheaply.
“While the 15 per cent trade-weighted appreciation of the dollar in the past 15 months has taken a heavy toll on US exports, the flipside is that the strength of the US currency has provided a helpful boost for many other economies,” he said.
“For example, exports from the eurozone and Japan to the US have risen by 19 per cent and 14 per cent year-on-year so far this year in local currency terms.”
Investors are expecting tightening
Capital Economics concludes that the final reason to be “fairly relaxed” about the US lifting interest rates is that investors are largely expecting an increase and have already factored it into their decisions.
“The 2013 ‘taper tantrum’ occurred because investors were surprised to learn that Fed officials were contemplating phasing out their QE programme,” Kenningham concluded. “In contrast, the rate hikes which we think are likely in the coming months have been largely priced in.”