History suggests that investors in US risk assets should not fear the start of Fed hiking cycle if it is in response to a robust economy and labour market rather than accelerating inflation.
Despite the heightened market volatility typically associated with the ‘1st hike’, credit spreads tend to fall and equity markets rise despite higher US Treasury yields. Nonetheless, each interest rate cycle is different and the Fed’s expected ‘lift-off’ in December will be against the backdrop of several years of unconventional monetary policies, a fragile global economy and a relatively mature US economic expansion.
The average performance of broad asset markets – US Treasury; equity; and credit – in the six months after the first Fed hike is summarised in chart labelled ‘Key macroeconomic indicators & Fed rate hiking cycles’ below. The S&P500 typically rises and credit spreads narrow, especially for investment grade corporate debt, offsetting the adverse impact of higher US Treasury yields.
Against such a backdrop, US convertible bonds have out-performed credit in each of the last three Fed rate hiking cycles. The performance of high yield credit has been more mixed however. The surprise Fed hike in early 1994 pushed high yield spreads higher and the asset class posted negative returns on the year. Similarly, US high yield credit spreads widened in 2000, though in response to rising defaults in the TMT (telecoms and media) sector rather than higher Fed interest rates. In contrast, during the last rate cycle from June 2004 to June 2006, high yield credit spreads fell more than 100bps and the asset class posted high single digit returns as default rates remained low. US Treasury 10-year bond yields also fell prompting then Fed chairman Greenspan to refer to the ‘bond conundrum’ in 2005.
BlueBay shares the markets’ current expectation that the US Federal Reserve will likely raise policy interest rates at its December 16 meeting, the ‘first hike’ in an interest rate cycle since June 2004. The following chart shows the evolution of key US macroeconomic variables during previous Fed interest rate cycles shown by the shaded columns.
The green line in the lower panel is the Fed funds target rate and the blue line is inflation measured by the price index for personal consumption expenditures excluding food and energy (‘core’ PCE). In the upper panel, the unemployment rate is shown by the gold line and the annual rate of economic growth by the red line. The solid blue bars are estimates of the ‘output gap’ – positive values indicate the economy is operating above ‘potential’ and negative values that there are under-utilised resources.
An interest rate ‘lift-off’ in December would be against a backdrop of lower unemployment than at the start of previous Fed rate hiking cycles, but also lower inflation and growth. The current output gap is also large in comparison with the position at the start of previous Fed hiking cycles and implies that there remains slack that would allow the economy to grow faster than potential over the next few years without generating domestic inflationary pressures. The ‘natural rate’ of unemployment – the level of unemployment consistent with stable inflation – and potential (or long-term trend) rate of economic growth are both estimated to be lower today justifying the Fed starting to ‘normalise’ interest rates.
In our opinion, the initial macroeconomic conditions for Fed ‘lift-off’ in December suggest that the Fed is not ‘behind the curve’ and is consistent with a gradual subsequent path for interest rates. The final destination point for US interest rates is also likely to be lower than in previous cycles – in the range of 2% – 3% rather than the 5% – 6% peak of recent Fed cycles – reflecting lower potential growth. Nonetheless, monetary divergence and uncertain prospects for China are likely to be catalysts for periodic ‘risk-off’ global growth scares and episodes of extreme market volatility.
Investors’ should not fear a cautious Fed tentatively beginning to raise interest rates but remain focused on the risks to growth and corporate earnings from the adjustment in China and other emerging economies and the deflationary forces arising from persistent global imbalances.
David Riley is head of Credit Strategy at BlueBay Asset Management