Why the Fed could hike THREE times in 2016

Some investors may already be prepared for an interest rate hike by the U. S. Federal Reserve on Wednesday. But that may not be enough: Fund managers are preparing for as many as three rate hikes in the coming year, and a lot of the rest of us could be caught off guard.

Managers surveyed by the Bank of America Merrill Lynch say that they expect the Fed to hike much more over the next 12 months than markets are currently pricing in. They also say that the risk of a recession next year has, in their view, now risen to 22.9 per cent.

The market is certainly pricing in a very high chance that the U.S. Federal Reserve will hike this week, but are investors prepared for the Fed’s rate to rise as high as one per cent next year?

Already, bond yields have spiked in anticipation of a rate hike, with the two- year Treasury note jumping to a nearly six- year high of 0.98 per cent Tuesday. Still, it appears that investors aren’t fully positioned for a rate hike, however, with markets apparently taking a wait-andsee approach.

“We find little remaining fear of Fed tightening, but investors are overwhelmingly waiting to increase their exposure to markets after the Fed,” said TD Securities analysts in a note.

There are expected to be significant changes in the market once the Fed does hike, however. The recent sell off in the high- yield corporate bond space highlights that adjustments are going to take place as the market weans itself off of rock bottom interest rates.

The leadership of U.S. equities is likely to also end, say analysts. While the S&P 500 has been one of the strong- est performing indices in the world in the past few years, tightening lending conditions for companies and stretched stock valuations will challenge performance in 2016.

Merrill Lynch found in its fund manager survey that an increasing number of managers are moving their money from the United States to Europe and Japan, which are most- favoured regions for overweights in 2016.

A Fed hike also has repercussions for the loonie. Canadian investors that have bought U. S. stocks in recent years without hedging have enjoyed the benefits of a rising greenback, which has made their investments more valuable when they are converted back to Canadian dollars.

The current consensus sees the U. S. dollar gaining further if the Fed does hike, but there are risks that the low loonie could snap back if the Fed becomes cautious in the coming months.

Fund managers surveyed by Merrill Lynch said that a sudden end to the Fed’s hiking cycle is the biggest risk to the end of the bull market for the U.S. dollar.

Of course, there are also risks that the Fed could surprise investors, either on Wednesday or next year. While the end of zero rates has been expected by the market for some time, a weak global economy and stagnating inflation continues to create an environment of heightened risk — meaning rate hikes are not a given.

“No one has successfully gotten off zero,” said Jim Bianco, owner and founder of Bianco Research, in a note to clients. “The Japanese tried in 2006 (hike once and then cut). The ECB tried in a 2010 hike (once and then cut to negative). What the Fed is about to do is unprecedented.”