Watch bonds for real Fed effect
If, as expected, Federal Reserve chair Janet Yellen initiates lift-off on Wednesday, or even if she doesn’t, there will be lots of analysis and chatter, much of it conflicting.
Are rising U.S. interest rates good, bad or indifferent? It’s a bit of a Rashomon exercise — the answer depends on who is looking.
To cut through the noise, investors will have to consider what matters and what really doesn’t when it comes to the first U. S. rate hike in nearly a decade. And they might want to remember that the impacts won’t be evenly distributed.
For what it’s worth, here’s my take on things we probably shouldn’t be worried about, and things we maybe should. Well, one thing in particular.
Let’s get the “probably shouldn’t worry” category out of the way first, beginning with the immediate market reaction.
A Fed hike might lead to more softness in U. S. markets over fears higher rates will stall the recovery and pump the greenback, hurting corporate profits. Or it might lift American (and Canadian and global) stocks as investors interpret liftoff as a vote of confidence in the U.S. economy.
On the other hand, if Yellen takes another pause, we might see markets go up or down, for the obverse reasoning of each of the above: a pause is good because low rates are good, or a pause is bad because it shows the economy is weak.
And so on. This is a conflict of interpretation we have witnessed before. Right now, the markets are pricing in about a 72-per-cent probability of an increase, according to Bloomberg. That’s down a bit recently, following a terrible week in U.S. and global markets — terrible, in part, because of an expectation that the Fed will move.
Whether the markets shudder again in advance of Wednesday, and how much the Fed cares — well, once again, we will just have to wait and see.
To my mind, the longer- term impact of rising U. S. rates on equities seems likely to be muted, for two reasons. First, the Fed has been telegraphing its intention for so long that the markets have largely priced in the impacts, positive and negative, which may simply balance each other out. And second, it’s clear that any rate hike process will be gradual and have a limited ceiling. By the end of next year, the U. S. will probably still be at historical lows.
Also in the “probably shouldn’t worry” bucket is commodities. Yup, a Fed move likely won’t do them any favours — in part because of the potential impact on emerging markets, and in part because commodities are priced in U. S. dollars — but given how weak these assets have been already, for a host of reasons that have continued despite lax monetary policy, a 25- basis- point rise in U. S. rates is probably not high on commodities investors’ concerns. In other words, “meh.” But maybe we shouldn’t be completely blasé about the Fed this week, because there is one area where concern might well be warranted: fixed income, particularly credit markets.
When rates go up, investors tend to demand more yield for taking on more risk relative to “safer” instruments (like government bonds), and prices tend to go down. We’re already seeing this in the riskiest chunk of corporate debt, where yields have been soaring. Borrowing costs for U. S. high- yield companies have risen by more than 50 per cent since June 2014.
Part of the reason for this sell-off is the expectation of rising rates. But another is the level of commodities’ exposure in high yield, especially of marginal producers hard hit by the continuing decline in prices.
If the sell- off in high yield deepens, or if it bleeds into higher-quality corporate debt, it couldn’t happen at a worse time. U.S. mutual fund managers have been loading up on credit in search of higher yield, but liquidity in bond markets has been severely constrained, thanks in large part to new regulation designed to mitigate systemic risk in the financial system.
The twin risks in high yield (interest rates and liquidity) were thrown into stark relief last week with the announcement from U.S.-based Third Avenue Management that it was liquidating its US$ 788- million distressed debt mutual fund — but freezing fundholder redemptions because there was no way it could sell assets off quickly enough to meet redemption demand.
True, Third Avenue might be a one-off event. Or it just might be the canary in the coal mine. If the run on corporate debt deepens, bond holders who want to get out might not be able to find buyers — raising the spectre of 2008, when a full- blown credit freeze followed the subprime mortgage crash of 2007.
The upshot: Investors will want to pay close attention to bond markets this week and beyond, whatever Janet Yellen does or doesn’t do on Wednesday.