Although the expectations of the first UK and US interest rate rises have got a lot closer as the year has progressed, we take central banks at their word that the pace of subsequent rate hikes will be gradual.
Historically, the Bank of England has raised rates an average of 4 or 5 times during each year of a hiking cycle. However, based on the Overnight Index Swap forward curve, current market pricing projects only 2 hikes a year for the next couple of years. This may be a little shallower than what the majority of investment bank economists are predicting (they’re calling for 3 hikes in 2016 with the first move in February), but either way, the pace is universally expected to be slower than previously.
In the US, the Federal Reserve (Fed) has actually raised rates in a more severe fashion in the past, averaging one hike every meeting which is 8 a year. Yet like in the UK, the market is again forecasting a much gentler slope of policy tightening in the US, pricing in just 3 rate rises a year. The Fed themselves, in their overly hawkish Summary of Economic Projections, state that they see a rate rise only every other meeting next year, which totals 4 – half the frequency of previous cycles.
So despite the symbolism surrounding the first rate move in almost 6 and a half years, fears of rising volatility and significant sell-offs in fixed income should be tempered. A 25bps interest rate rise in either the UK or the US would still mean exceptionally loose monetary policy by historical standards, and the path of rate rises is only expected to be gradual thereafter. Global growth concerns remain, fuelled by the slowdown in China, and the deflationary impact of falling commodity prices around the world should suppress any dramatic yield rises from here. This is particularly pertinent for longer-term yields which could be kept low as the inflation premium diminishes, allowing the yield curve to flatten as the short end rates rise with the base rate. Furthermore, the European Central Bank is buying up €60bn worth of European bonds every month as part of their quantitative easing programme which shows no sign of abating – higher-yielding gilts and treasuries in the UK and US are likely to remain relatively attractive to European investors.
However, we feel there could be more value in the FX markets over the medium term. In line with our expectations of a more gradual, data-dependent policy path, we even foresee a period of time where these major central banks could potentially pause tightening midway through the cycle. In this scenario, I would expect the benefits of a long US dollar strategy to dissipate. In turn this may provide an opportunity to build positions in currencies which have suffered of late due to falling commodities, and that could suffer more over the near-term as their central bank’s policy has diverged from that of the Fed.
Jack Parker is deputy fund manager on Invesco Perpetual’s Fixed Interest team