A December Rate Hike Would Not Be the Fed's First Act of TighteningLearn more about this firm
- Investors preparing for the shock on risk-on assets as a result of Fed tightening may be surprised to realize that they have already been feeling these shocks.
- The impact of a single 25 basis point hike as a part of a slow, years-long rate-rise cycle will likely be modest compared to the impact of the end of QE3.
- Now that panic has retreated following August and September’s volatility, the view that a rate hike is not a death knell for portfolios, whether risky or not, is emerging once again.
The Federal Reserve’s decision to keep rates low once again at its October meeting was not a surprise to markets, but the hawkishness of its statement was. Since then, the momentum behind a rate hike before the end of the year has accelerated as Fed Chair Janet Yellen and New York Fed President Dudley both reiterated the possibility of a December increase. The unequivocally positive October jobs report only furthered the momentum, showing for the first time since the financial crisis that the seed of wage growth is sprouting in a much more fertile labor market environment.
Suddenly, investors across asset classes are no doubt wondering with renewed urgency how monetary tightening in the U.S. will affect their portfolios: how will stocks, bonds or emerging market securities react? The truth is, however, that the Fed’s tightening cycle is not almost here, it has already begun—even though the fed funds rate remains unchanged.
The Fed’s first rate hike since 2006 will be a watershed moment, but considering the broad array of tools the Fed has used since the onset of the financial crisis, it is just one of many such moments. To see the Fed’s first piece of tightening, we have to go back to December 2013 when then-Fed Chair Ben Bernanke announced the tapering of asset purchases of QE3. Tightening gained steam when QE3 officially ended in October 2014. Without the impact of the Fed’s monthly purchases of $85 billion in mortgage-backed securities, the Bloomberg US Financial Conditions Index has fallen by approximately 50% to 0.44, indicating that financial conditions are still accommodative compared to pre-crisis levels but significantly lower than prior to the end of QE3.
Investors preparing for the tightening’s shock on risk-on assets in the coming months may be surprised to realize that they have already been feeling these shocks. Granted, they have been coupled with other major shocks emanating from China and cratering commodity prices, but they have certainly begun. In fact, China’s August devaluation of the yuan against the dollar, which brought other worries about China to the forefront, can reasonably be seen as a strategic move to react to the U.S.’s tightening cycle and currency strength. After all, the cost of maintaining the yuan’s exchange rate with the dollar was progressively becoming more of a burden.
In this context, the tremendous performance of the U.S. dollar in the last year is understandable. The Dollar Index, which measures the U.S. dollar against ten major currencies, has appreciated by over 20% since December 2013 when the taper was announced by then-Fed Chair Ben Bernanke. This movement has not occurred in a vacuum, however. It has been amplified by the fall in oil prices and divergence of the U.S.’s monetary policy compared to other major economies. This movement stands in contrast to the action seen during QE, which depressed the value of the dollar (outside of QE3, which was concurrent with new bursts of easing from Europe and Japan).
Source: Bloomberg, Columbia Threadneedle Investments
In light of this, memories of summer 2013’s taper tantrum, when emerging market asset prices were decimated following rumors that the Fed would rein in its easing, might seem primed to reemerge when the Fed begins raising rates. Although the ride may not be smooth, it is worth remembering that many currencies have felt the brunt of this negative action already. For example, the Mexican peso has depreciated by 16% and the Polish zloty by nearly 14% against the U.S. dollar, despite exhibiting no exogenous shocks (such as Brazil’s corruption and fiscal scandals, or Russia’s sanctions). Moreover, the impact of a single 25 basis point hike as a part of a slow, years-long rate-rise cycle will likely be modest compared to the impact of the end of QE3.
With a longer term view, a rate hike by the Fed is more important as a headline item than for its substance. This is important, especially for emerging markets. The U.S. economy is growing at a reasonable and sustainable rate. With a strong dollar to go along with that, emerging markets will once again be the beneficiaries of American firms and consumers spending their money on inexpensive imports. This narrative was beginning to emerge before August’s market turbulence, but was swept away from the mind of investors as more short-term worries took over. Now that panic has retreated following August and September’s volatility, the view that a rate hike is not a death knell for portfolios, whether risky or not, is emerging once again.