After months of speculation and several aborted attempts, the world’s most powerful central bank finally acted. The decision by the US Federal Reserve (‘the Fed’) to raise its target range for the Federal Funds rate by 25 basis points had been relentlessly telegraphed in the weeks leading up to yesterday’s meeting, and financial markets responded positively after the news. 
The US dollar strengthened against most major currencies, short-dated treasury yields climbed to their highest level since 2010 and equity markets across the world rose as policy makers said the trajectory of further interest rates rises would be “gradual”.
The Fed indicated that it will maintain the size of its balance sheet until such time as the process of normalising interest rates is “well under way”.
Yesterday’s decision marks the end, temporarily or otherwise, of an extraordinary period which has seen the Fed keep rates at record lows for nearly a decade in an attempt to stimulate an economy ravaged by the effects of the global financial crisis.
Performance of indices since the global financial crisis
Source: FE Analytics
Supporters of the move cite several reasons why the Fed was right to hike. The US economy has been growing steadily for nearly five years. Unemployment continues to march downwards and now stands at 5 per cent.
Many of the problems that affected the economy during the crisis have now been resolved. The banking sector has been recapitalised, the housing sector is in much better shape and US corporate profits have been at or close to record highs for some time.
All of these factors suggest that emergency low rates are no longer needed more than seven years after the crisis began.
Was it the correct decision? Monetary policy operates with a time lag, and it will be several months before we can assess the impact of the Fed’s move on the US economy.
However, a number of leading indicators suggest to us that the US economic recovery is less secure than is commonly believed. The Evercore ISI Company Surveys, a weekly sentiment gauge of American companies, has weakened this year and is currently hovering around 45, suggesting steady but not spectacular levels of output.
The Atlanta Fed’s ‘nowcast’ model indicates underlying economic growth of 1.9 per cent on an annualised basis in the fourth quarter, a level consistent with what many believe is a ‘new normal’ rate of US growth of between 1.5 per cent and 2 per cent.
More worryingly, the slowdown in global trade now appears to be affecting US manufacturing.
The global economy is suffering from acute oversupply, not just in commodities but across a range of sectors, and industrial output in the US is now starting to roll over. Historically, the Fed has only begun to raise rates when the ISM manufacturing purchasing managers’ index (PMI) has been in the mid-50s. It is now in the high 40s.
The only exception was in the early 1980s, when the US economy was suffering from stagflation.
At the time, the manufacturing PMI was in the low 40s, but the prices paid component of the index was in the high 80s. Today, the prices paid component is in the mid-30s, suggesting that the industrial sector is being affected by deflation.
In my view, the weakening industrial data makes it unlikely that this move will be the start of a lengthy tightening cycle by the Fed. Some economists argue that because manufacturing is a relatively small sector of the US economy, there is little reason to worry.
But the same was true in 2008, when industrial weakness subsequently spread to the larger services sector.
With growth slowing in the rest of the world, in our view there is a genuine risk that the Fed will end up doing ‘one and done’.
Longer term, the ability of central bankers to normalise policy is constrained by powerful deflationary forces, including aging demographics, high debt levels and the impact of disruptive technology and robotics, a reason why we are comfortable maintaining an above- consensus duration of over five years.
Much of that duration is accounted for by a position in medium and long-dated US Treasuries and Australian government bonds.
The US credit cycle has turned
The Fed’s action also comes at a dangerous moment for US credit markets. We believe the US credit cycle has turned.
Performance of indices in 2015
Source: FE Analytics
Credit fundamentals have been deteriorating for some time. Leverage levels have been moving higher on the back of aggressive M&A activity and share buybacks as corporates have been shifting their focus from repairing balance sheets to enhancing shareholder returns.
Our impression from recent company meetings is that many US businesses are highly leveraged.
These ‘zombie’ companies have been kept alive by the Fed’s zero interest rate policy. As soon as the Fed signalled its desire to bring this policy to an end, credit markets began to react. It’s worth emphasizing that this is not just a commodities problem.
We are beginning to see credits from a wide array of sectors come under pressure, including paper, telecoms and retail.
For some time, we have been concerned that the risk of a policy error by the US Federal Reserve has increased. A key objective of Federal Reserve policy has been about stimulating financial markets and creating a wealth effect.
This desire led to an extraordinary period of largesse which has seen the Fed’s balance sheet balloon to over $4tn since 2008 and ignited a carry trade that is estimated to be worth $6 trillion, a trade which I believe has created a massive misallocation of capital. We’ve seen what this misallocation has done to commodities, but I suspect that there has been a misallocation of capital to credit markets in the hunt for yield.
The decision to hike in December suggests to us that the Fed is looking to atone for its failure to begin normalizing monetary policy earlier in the cycle, before the imbalances in the global financial system became so pronounced. In our view, the Fed should have started raising rates several years ago, before its actions had created a massive misallocation of capital and bubbles across many asset classes.
In our view, it is likely that US rates will return to their previous lows at some stage in the next few years.
US high yield flashing red
Much has been written over the last few days concerning certain US funds that have frozen redemptions.
In addition to this we have seen material outflows from US high yield mutual funds. We have been concerned about US high yield for some time, and have limited exposure to this market.
Furthermore, the other concern we have had for a while is some sort of contagion to European credit as credit in emerging markets and US credit have continued to come under pressure.
For this reason we have been reducing our European high yield exposure and within our high yield bucket we have been improving the quality and also preferring shorter dated paper. In emerging markets, corporate balance sheets have also been deteriorating as again corporates have taken on material amounts of leverage and in many areas of emerging markets, economies have been running into trouble.
Performance of sector over 3yrs
Source: FE Analytics
We believe the problems in many emerging markets are somewhat protracted and hence we continue to avoid much of this space.
In Europe, broadly speaking, we believe the credit cycle is somewhat less mature. Therefore balance sheets are generally in better shape. Hence we continue to favour European credit. However, idiosyncratic risk, even here, is beginning to pick up.
Abengoa (which we didn’t own) is a very recent example of how small cracks are starting to appear in Europe.
The other big risk to credit has been liquidity.
Due to regulatory reasons investment banks simply cannot support the markets as well as they did in the past. At this late stage of the credit cycle, and with the Fed tightening policy even further (the combination of a strong dollar and quantitative easing coming to an end in the US is a tightening of economic conditions in our opinion) caution is warranted.
Recent events justify why we have adopted this barbell approach of having our top picks across high yield (primarily European high yield) countered by high quality investment grade credits and a material position in high quality government bonds such as US treasuries, Australian government bond and New Zealand government bonds.
FE Alpha Manager Ariel Bezalel is manager of the £2.6bn Jupiter Strategic Bond fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
