Will the Fed spook markets once it starts rate hikes?

Mr Richard Jerram, Chief Economist, Bank of Singapore, and member, OCBC Wealth Panel, gives his insights on Federal Reserve interest rates

BACK in May 2013, then-Federal Reserve Chairman Ben Bernanke scared financial markets when he talked about tighter United States monetary policy, triggering what has become known as the “taper tantrum”. Markets around the world reacted negatively, with some vulnerable emerging economies feeling particular pain.

For the past year, the timing of the first increase in the benchmark US interest rate - which has remained at an unprecedented 0 per cent since December 2008 - has been the primary focus of financial markets, with only occasional interruptions from events in Greece or China.

When the rate hike finally happens - probably at the next Federal Reserve policy meeting in mid-December - it is hard to believe that anyone with a moderate interest in investing will be surprised.

The Fed has approached monetary tightening extremely cautiously, partly because it has seen some central banks in developed economies raise interest rates prematurely, only to have to take them back down again as growth faltered.

Now that the US economy has reached full employment, it is hard to argue that zero interest rates are still justified.

So how much will a rate hike affect the US economy and financial markets? The answer is probably not very much, says
Mr Richard Jerram, Chief Economist of Bank of Singapore.

Accommodative policy

This is because even if interest rates gradually push higher through 2016 and 2017, they are likely to be below normal levels for at least another couple of years, he says.

“Fed officials have made it clear that policy will remain accommodative,” he explains.

“Combined with roughly neutral fiscal policy, this should allow the US economic recovery to continue, and inflation will nudge back up towards the Fed’s 2 per cent target.”

While some people worry about the timing of the rate hike - when there are doubts over growth in China - exports to China account for less than 1 per cent of the US economy, Mr Jerram says. 

Residential construction, meanwhile, is four times as important and that sector is recovering well, as a long period of subdued activity after the financial crisis has led to a shortage of housing.

The American consumer is in good shape as well, with tight labour markets and signs of stronger wage growth, while also enjoying the benefits of capital gains on real estate and financial assets, he says.

“The net worth of American households has never been better, so it is not surprising to see income growth translating into stronger spending,” he says.

Still a bull market

However, even if the economy is relatively untroubled by the prospect of higher borrowing costs, it is still possible for financial markets to react badly.

History suggests that equity markets may be volatile for a few months around the time of the first interest rate increase, but this should not signal an end to the bull market.

“The reason to be comfortable with equities is simple - the favourable economic conditions that are leading the Fed to tighten policy should also be helpful for the earnings of the corporate sector,” Mr Jerram explains.

And while valuations are a little high, they are not particularly expensive, he adds.

“Equity markets typically only need to worry when the central bank is raising interest rates to choke off growth in response to high inflation that is coming from an overheating economy, and that risk still seems to be several years away,” he says.

“On the other hand, it is probably a different story for bond markets, especially low-yield investment grade bonds. These assets will look less attractive as short-term interest rates rise (confusingly for some, bond prices fall as yields rise). There are some concerns that investors might have collectively locked too much money in them over the past seven years as they sought higher returns in a zero-interest rate environment.” 

OCBC advises that investors avoid this area, especially as the bank thinks that the Fed will need to raise interest rates faster than the market currently expects, Mr Jerram says. The market is expecting only five Fed rate hikes by the end of 2017, which would be an extraordinarily slow pace of tightening. Jerram thinks we could see twice as many.

In the forex markets, participants also seem to be assuming that the US dollar will rise once the Fed begins to hike interest rates.

This is less clear-cut than it might seem, Mr Jerram cautions, because the dollar was flat during the previous policy tightening cycle, and in the one before that, it actually declined.

“Foreign exchange markets are complex and unpredictable beasts and they can often bite over-confident investors,” he says. “A rule-of-thumb is that if everyone expects something to happen - like a rising US dollar - then it rarely does.”

Overall, investors should take the first Fed interest rate increase as a sign of a gradual return to normality, after years of abnormally loose policy, OCBC says.

While there will be some volatility in markets for a few months, the change has been so well signalled by the Fed that it should not prove to be very disruptive.

OCBC has more than 40 analysts - derived from a research platform consisting of OCBC’s private banking subsidiary Bank of Singapore, OCBC Investment Research, OCBC Bank’s Global Treasury and Global Consumer Financial Services divisions - who specialise in scrutinising the markets globally for in-depth investment coverage that spans over 700 securities and 31 currencies. OCBC Premier Customers do not need to read through many reports, instead the bank helps to provide an unified house-view through well-researched information that is easy to understand and apply.

In my view
How are you personally preparing for a possible Fed rate hike?

Three ways. First, by not worrying too much and not making any big portfolio moves, as I think the shift is largely expected and already factored into prices.

Second, by building some cash in case short-term volatility creates some buying opportunities.

Third, I have a reasonable exposure to US banks — they look relatively cheap and should benefit from the improving economy that is behind the rate hike, as well as the wider lending margins that will follow.

Mr Richard Jerram
Chief Economist, Bank of Singapore
Member, OCBC Wealth Panel