As per the latest US Federal Reserve’s meeting in July, the interest rates were not raised even though the US economic scenario suggested for just the opposite. The US central bank maintained the target range for the federal funds rate at 0.25% to 0.5%. However, three things that took a firmer shape through this meeting entail:
Possible interest rate rise later this year: After a two-days meeting, FED issued in a statement that they “opened the door to an interest rate increase later this year, possible as early as September”. This means there could be a rise in interest rate in September. FED has kept the rates on hold for this month and indicated that there would be a rate hike in the coming months. The rates have been unchanged since a modest rise to 0.5% in December. This was the first increase in seven years since base borrowing costs were cut dramatically to boost the economy after the financial crises. The market is expecting two more rate hikes in this year. A Reuters poll of economists suggested that the Fed might wait until December to raise rates. Rising rate means the economy is accelerating out from a slow-growth environment. While some investors argue that the slowdown in the economy prevails, this move from the fed could renew the confidence in the market and give equity investors the opportunity to capture additional gains. Meanwhile, companies have been taking advantage of low rate environment and accordingly, borrowed money via bond markets. A quarter point increase is likely to have a negligible impact. However, the interest payments for companies issuing a low grade could rise very fast.
Weightage to statistical outcomes: The recent US job market data indicated addition of 255,000 positions in July while the headline unemployment rate stood steady at 4.9%. In June and prior to the Fed’s decision, job market reported to have 287,000 additions while the GDP showed a modest improvement. With respect to June’s data, the unemployment rate stood at 4.9% while GDP grew 1.2% although it was the fourth consecutive quarter to report sub 2% growth for the US economy. These signs of small economy improvement signal for the rate hike. Consumers are also better prepared now for higher borrowing costs with the gradual fall in burden on household debt. The rise in interest rate would thus result into expensive financing cost for loans, mortgages etc. On positive side, the interest on deposit to rise will make savings more attractive.
Interest rate forecasts (Source: Federal Reserve)
Global markets’ reaction: Markets reaction was mixed on the US fed decision. Dow Jones Industrial Average (INDEXDJX: .DJI) slightly fell over 0.87% from July 27, 2016 to August 02, 2016. This fall could be attributed to weak earnings by big firms. On the other hand, NASDAQ 100 (INDEXNASDAQ: NDX) surged over 1.01% from July 27, 2016 to August 02, 2016 as higher interest rate seemingly indicated for a better economic growth. It could renew the confidence in the market and give equity investors the opportunity to capture additional gains. Gold may lose its shine while bond market looks more exposed, highly rated debt is trading with very low yields, indicating that they are vulnerable to even a modest rise in Fed interest rates. The bonds issued by companies rated junk could however suffer.
Meanwhile, the rise in interest rate would make the dollar stronger and this has been reported to dampen the values of emerging market currencies which are already at an edge towards weakness. Additionally, the emerging markets’ currencies have already sagged against the US dollar which can, in turn, create more turmoil. Further, it would likely to see major capital outflow, and increasing market volatility during that period. All these would have worse impact on economies with large current account deficit, high external borrowing relative to reserves, high inflation and deterioration in economic fundamentals. The fall would warrant the Central Bank’s intervention to dent sharp currency depreciation and stabilize the market.
Historical performance of Asian markets on event of interest rate hikes (Source: Morningstar Direct)
On the other hand, Federal Reserve policymaker Jerome Powell has recently mentioned that the US economy is at increasing risk of becoming trapped in a prolonged phase of sluggish growth and this that points to the need to have lower interest rates. Thus, Fed’s stance on the interest rates going forward, will be more clear with time and other economic developments.