After nearly a decade, the Federal Reserve (Fed) raised rates this week by 25 basis points. According to the Fed’s statement, this move comes after an expansion in household spending and business fixed investments, as well as declining unemployment. For years, investors have focused on when the Fed will raise rates, and with this first move, the market is beginning to digest the ramifications. In addition to the week’s rate rise, the Fed outlined expectations for a series of further rate rises in 2016 that will total 1%. That said, Eurodollar futures indicate market participants are betting that the Fed will raise rates by only another 50 basis points or so. Despite the differences in opinions between the Fed and Wall Street (and investors taking positions contrary to the old Wall Street saying “don’t fight the Fed”), the first important step has been taken: rates are rising!
Before we discuss the immediate impact of this rate rise on markets, it is important to note the discrepancy between investors’ and the Fed’s views on rates. As a reminder, Eurodollar futures allow investors to bet on the future of the London Interbank Offer Rate (LIBOR), which is the rate that banks can borrow from each other on the London interbank market. This rate ties closely with the Fed Funds Rate, except in times of heightened credit concern, such as the 2008 credit crisis, as they both are interbank lending rates. However, the Fed has more control over its rate; hence the large, and seldom seen, spread gap between the two during the credit crisis. Investors using Eurodollar futures are assuming that the Fed most likely will raise interbank rates in one year to a level that is about 53 bps higher from where they are today, rather than to the expected 1%. This is a bearish view, as futures buyers are saying, in essence, that the Fed will have to raise rates more slowly because of slowing economic activity, a point investors should note.
Despite the difference in opinions between Wall Street and the Fed on rates, the stock market’s initial reaction was positive: stocks spiked on the news that many had been anticipating for years. Investors finally gained some clarity around rates, and seemed to be relieved that there was a decision. Wednesday’s good news quickly turned sour on Thursday, as investors looked past the Fed hike and focused on the continued decline in commodity prices and slowing manufacturing measured by the Philly Fed Index. US crude oil hit a low that had been unseen since February 2009, and energy stocks were down almost 2.5%. In addition, the stronger dollar that comes with rate hikes will have a negative impact on exporters. Surprisingly, investors looked for safety in higher yielding stock names on Thursday (despite concerns amongst certain investors that these stocks would suffer during a rate rise as the quest for yield ends), and only the Utilities sector ended the day in positive territory.
After the hike, 10-year treasury yields bounced around, but declined by close of business Thursday. In other words, there was little to no impact on the 10-year bond. That said, 2-year treasury yields rose almost 8 basis points since Monday in preparation for the hike. For future home buyers, mortgage rates rose slightly: up 3 basis points, from 4.06% last week to 4.09% as of December 16, according to bankrate.com, as mortgage rates are tied more to the 10-year yield than to Fed Funds. In other words, fixed income markets have been preparing for this hike for a long time and, despite a continued debate over the long term path of Fed Funds, the bond market’s reaction was muted.
Although many investors and analysts are concerned about global growth, we view the rate hike as a positive—it provides clarity to the market and, more importantly, allows the Fed to reload. In particular, economists are concerned that if we were to enter another recession with 0% rates, the Fed would have no ammunition to stimulate the economy by lowering rates, and instantly would need to begin another round of Quantitative Easing. If rates are higher, the Fed has more tools to stimulate the economy, rather than turning back to the printing press. We must remember that we are far from normal monetary policy. Despite this week’s rate rise, the Fed’s balance sheet is still at incredibly elevated levels—almost $4.5 trillion—almost double the amount of assets it held in 2010. This week’s rate hike was a good first step, but we have a long way to go before we enter “normal” monetary policy nearly 8 years after the credit crisis began.