PMC Weekly Review - March 17, 2017

A Macro View: Don’t Fight the Fed – Monetary Tightening and Global Markets

As expected, the Federal Reserve raised the federal funds target rate from a range of 50-75 basis points up to 75-100 basis points at this week’s FOMC meeting. The Fed has telegraphed its desire to normalize monetary policy for some time, but over the past two years, economic data precluded it from doing so more than once at the end of each calendar year. With more robust macroeconomic data to start 2017, the central bank jumped on the opportunity to raise interest rates, a move that markets had priced in as a near certainty, following aggressive forward guidance. Both debt and equity markets rallied on the news, as the statement accompanying the rate hike was viewed as more dovish than many expected. The question remaining for investors, however, is how aggressive will the Fed be going forward, and what will this mean for markets in the months ahead?

We all know that rising interest rates are bad for bond valuations. When interest rates go up, the income earned by bondholders on their current holdings suddenly becomes less competitive than what is being offered in the new issuance market, making their bonds less valuable. One way bond investors have been able to avoid this problem historically is by holding securities that are less vulnerable to changes in interest rates and more sensitive to underlying credit fundamentals. However, the difference in this tightening cycle is that investor’s yield-chasing behavior in the years since the financial crisis has greatly reduced the spread offered by riskier fixed income assets, which in the past has helped protect these securities from price erosion due to rising rates. Based on the heightened level of current valuations across the majority of fixed income sectors, there are fewer places to hide from the negative impact of rising rates.

Historically, equity markets have performed well during the onset of a rising interest rate environment, but then declined as the tightening cycle tends to eventually stall the economy and adversely affect corporate bottom lines. One exception is the Financials sector, which benefits from the increased spread between borrowing and lending. Unsurprisingly, income-generating stocks can be more susceptible to rising rates, and in general, these stocks already trade at high valuations—the result of an aggressive bid from yield-hungry investors. Ultimately, historical tightening cycles have occurred in different economic environments, and have had mixed results for equity markets. The last sustained period of rising interest rates was more than 30 years ago, and from a much higher base, meaning there may be some uncertainty around how an upward trajectory in rates might affect equity markets this time around, and uncertainty usually means higher volatility.

Fed policy also has a multitude of macroeconomic effects that affect both global and domestic markets. In the near term, the yield differential caused by the increasing divergence between the Fed’s policies and those of other major central banks (namely the European Central Bank and Bank of Japan) should further encourage capital flows into the US, placing a ceiling on US rates and strengthening the US dollar. However, over the longer term, investors should consider the potential effects of the eventual unwinding of quantitative easing in Europe and Japan (making bond yields more attractive to investors in their respective markets), which should lead to reduced demand for US bonds and the dollar, likely undermining many of the market trends that have developed over the past few years. Higher borrowing costs could hamper the US consumer, the engine of the American economy, as well as firms with less viable business models, or those that rely heavily on debt financing. In addition, a strong dollar makes US exports more expensive for foreign buyers and imports cheaper for American companies and consumers. This can be either positive or negative for US corporations, depending on whether the firm is a net importer or net exporter. Further complicating matters is the uncertainty surrounding the new administration’s policies, particularly those related to foreign trade and domestic growth and inflation, the latter of which could induce more aggressive Fed tightening in the future.

Clearly, the Fed has embarked on a policy path that will likely influence significantly both asset prices and the real economy. Although it remains to be seen how many additional rate hikes we’ll ultimately see in 2017, investors must be cognizant of the impact these decisions might ultimately have on their portfolios, and position themselves accordingly.

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