The Fed loosens the reins

Christian Kopf joined Union Investment in September 2017 as managing director and Head of Fixed Income. Mr Kopf is one of the Union Investment Committee’s six voting members. On a monthly basis, the UIC lays out Union Investment’s asset allocation and thereby sets guidelines for tactical fund positioning by the firm’s portfolio managers.

Until recently, financial market analysts were in agreement that the US Federal Reserve (Fed) would maintain its policy of steadily raising key interest rates over the course of 2019. Key interest rates in the US, which had already reached a range of 2.25 to 2.5 per cent by the end of 2018, were expected to increase by a further 75 or even 100 basis points in 2019. That was the consensus at the end of 2018. The situation today looks completely different, leaving many observers scratching their heads in disbelief. Analysts now predict barely any further interest-rate hikes in 2019, and the markets are pricing in no further raises at all. What has occurred to generate such a quick and comprehensive change of opinion? And what does the shift mean for the capital markets?

The reason for this sudden change of heart lies in the markets themselves. In actual fact, there are still good reasons why the Fed should continue to put up key interest rates: US unemployment is at its lowest since the end of the 1960s, wages have recently been rising sharply (the latest year-on-year increase was 3.3 per cent) and this means a degree of upward pressure on inflation going forward. In its second-longest upturn of the past 70 years, the economy is, in short, threatening to overheat, which ought to make it the right time for higher key interest rates.

Indirect impact of a key interest-rate hike on the economy and capital markets

Changes to key interest rates have a mainly indirect effect on the economy and capital markets due to four transmission mechanisms that often interact with each other:

  1. Higher short-term interest rates – and only here is the Fed able to directly exercise influence through key interest rates – tend to indirectly lead to higher yields on long-dated government bonds. In turn, this pushes up mortgage rates for residential property purchases. The result is subdued activity in the construction industry.
  2. Moreover, higher key interest rates usually lead to higher risk premiums on corporate loans and bonds. This makes companies’ capital expenditure more expensive and may prompt some company executives to put expansion plans on ice. In turn, this holds back the new lending business and results in fewer new issues in the capital markets.
  3. Higher key interest rates often lead to weaker share prices too. As people in the US mainly opt for personal retirement pensions that invest in the stock market, their assets then decrease. Households typically react to such situations by limiting personal consumption, which in turn takes its toll on demand in the wider economy.
  4. Finally, higher key interest rates usually result in appreciation of the national currency. This makes exporters less competitive and increases imports, in turn contributing to a worsening trade balance and thus weaker economic growth.

Barely any negative effects since 2015

Key interest rates therefore have a mainly indirect effect on economic growth due to their influence on general financial conditions, i.e. yields on government bonds, spreads on corporate bonds, share prices and the national currency. Since the Fed began its series of key interest-rate hikes in autumn 2015, however, barely any tightening of financial conditions has been observable in the US economy. Despite higher key interest rates, share prices have continued to climb, spreads on corporate bonds have held steady and the US dollar has appreciated only modestly. Given that its monetary policy had largely no effect over a long period, the Fed had good reason to carry on steadily raising key interest rates.

Tightening of financial conditions in the fourth quarter of 2018

But the situation changed in the fourth quarter of 2018, when there was a sharp and sudden tightening of financial conditions. The equity markets came under severe pressure, while spreads on corporate bonds widened significantly to an extent that could not really be offset by the fall in yields on government bonds. It is clear that this sudden shift in the situation in the capital markets will adversely affect US economic growth, albeit not immediately. Consequently, there are now many reasons why the US central bank should be more cautious about raising interest rates again and thus slightly loosening the reins for the real economy.

Verbal intervention: data dependency, not autopilot

This is exactly what the Fed has communicated in statements made by its top monetary policymakers: a stronger focus on the consequences of Fed action on the real economy and even suspension of the further interest-rate rises that were originally planned. Richard Clarida, Vice Chairman of the Federal Open Market Committee, stated at the beginning of January that “growth and growth prospects in other economies around the world have moderated somewhat in recent months, and overall financial conditions have tightened materially”. His conclusion was that “if these crosswinds [to the US economy] are sustained, appropriate forward-looking monetary policy should respond [to them]”. So the Fed is already indicating its intention to exercise greater caution about interest-rate rises – and rightly so in our opinion. The capital markets have heeded these signals and are now pricing in no further interest-rate hikes. The interest rate for forward contracts for the end of 2019 stands at 2.4 per cent, which is virtually identical to the current level.

But has the end of the cycle of interest-rate rises in the US really been reached, as the markets currently believe? We are slightly more cautious in our assessment. The main reason for this is that the US employment trend remains very positive, with 312,000 new jobs added in the US during December alone. Another reason is that the fall in long-term yields since October 2018 is already benefiting interest-rate-sensitive sectors of the US economy. Mortgage rates in the US have dropped by 0.2 percentage points, thereby pushing up demand for housing and reinvigorating the building industry. We therefore predict one or perhaps even two further interest-rate rises in the US this year, provided that economic conditions and the situation in financial markets do not deteriorate further and provided that the economy is not thwarted by politicians, a no-deal Brexit or escalation of the trade war between the US and China. In any case, it is crucial for the capital markets that the Fed switches off the autopilot and thus does not raise interest rates by a further 0.25 per cent every quarter. Instead, it needs to make its monetary policy more dependent on developments in financial markets and in the real economy. This should help to ease tensions in the capital markets, particularly the markets for corporate bonds and for bonds from the emerging markets.

A question of opportunity costs

In the environment of low interest rates that has prevailed since the global financial crisis, many investors have moved into riskier asset classes because they were no longer able to generate sufficient returns from safe forms of investment. Last year, these reallocations were reversed – at least in the US – as short-term safe interest rates had risen to almost 2.5 per cent. Against this backdrop, investors asked themselves why they should transfer their money to asset classes that promise a return of perhaps 5 per cent but, at the same time, suffer volatility of 5 or 6 per cent, when they can safely put it in fixed-term deposits without fluctuation that offer a return of 2.5 per cent. This question became increasingly relevant with each interest-rate hike implemented by the Fed, especially as further raises were in prospect. This was one of the reasons for the outflows from corporate bonds and emerging markets in 2018.

As it is now becoming apparent that safe interest rates in the US will no longer continue to rise steadily, investors are again becoming more aware of the appeal of higher-yielding alternatives. Consequently, 2019 could be a good year for corporate bonds and for bonds from emerging markets. The Fed is loosening the reins a little – which means that the US economy will not come to a complete standstill – and slightly riskier asset classes could start delivering a better performance again.

 

As at: 25. February 2019.