As we all know, the Federal Reserve in the US has raised interest rates by 25 basis points for the first time since June 2006. Even an interest rate hike of this size will have financial repercussions around the world. Today I’m looking at the knock-on effects of this policy decision on the financial markets.
US Dollar weakening
In theory an interest rate rise should make the dollar more attractive, but history tells us that when the Fed increases interest rates the dollar can weaken slightly. This rate rise was seen from a long way off and is likely to have been priced into the dollar already. The US dollar has been one of the best performing assets in the last few years and many market commentators believe this decision will take the juice out of its appreciation.
Commodities to rise
Historically, commodities have had bullish periods following rate hikes and any dollar weakness would also improve commodity prices as most are quoted in the currency. In the first six months after the start of rate hike cycles Brent crude has returned an average of over 15%. Gold also tends to outperform after rate hikes averaging 12% in the first 12 months. As gold and oil are both sitting at lows, we could see a rally next year that would finally provide commodity investors with something to celebrate.
Relief rally in equities
The markets reacted well to the Fed decision and I believe that equities will continue to rise into the first half of next year. The S&P 500 has averaged a 6% gain in the first six months after the start of rate hike cycles. The Fed made it quite clear that a rate hike would be coming in December after the ‘false starts’ of September and October, and this has provided equities with a reason to rally.
Bond yields to rise
When interest rates rise, bonds tend to decrease in price and send yields much higher. The small rise of just 25 bps is a clear indication that the Fed is still worried about market reaction. The bond markets have remained relatively unchanged since the decision due to the fact that the rate rise was well documented and predicted. Next year will be a crucial one as the Fed must get the rate of rise spot-on to prevent bond markets from beginning to suffer. It will hope to keep the bond markets stable and hope that yields stay relatively constant. This is a key target for this rate cycle.
The interest rates decision last week was a big moment in financial markets and will affect all asset classes for years to come as the Fed continues with this rate hike cycle. Currently commentators see interest rates at between 2.75% and 4% by 2018. But there’s a strong argument to say that the Fed will raise rates much more gently to keep stability in global markets.
These macro-economic issues must be part of every investor’s research and thought process.
