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Pensions

Fed raises rates for first time since 2006

Fed raises rates for first time since 2006

By Chris Panteli
Thursday 17th December 2015

The Federal Reserve has raised interest rates for the first time since 2006, in a move widely expected by markets.

The Federal Open Market Committee (FOMC) voted unanimously at its December meeting on Wednesday to raise interest rates in the US by 25bps to between 0.25%-0.5%.

The US dollar rallied and treasury yields spiked in the wake of the announcement, with the dollar trading 0.5% higher against sterling at $1.4975 in the immediate aftermath, while 10-year treasuries spiked to 2.3%.

The rise marks the first time the Federal Funds Rate has moved from the record lows of 0%-0.25% since the darkest days of the financial crisis in December 2008.

In its statement, the FOMC said: “The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2% objective.

“Given the economic outlook, and recognising the time it takes for policy actions to affect future economic outcomes, the committee decided to raise the target range for the federal funds rate to 0.25%-0.5%.”

Inflation remains below the Fed’s 2% target, however, and the statement by the central bank acknowledged the drag from declines in energy prices and in inflation expectations, even though it still expects to reach its target “over the medium term”.

The result is that any future rate hikes will be slow. “The committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen,” the statement continued.

The central bank expects US unemployment rates to remain at their current level of 5% this year, and fall to 4.7% in 2016.

While the move was widely expected by markets, many believe there may be more challenging times ahead, particularly for bonds.

Royal London Asset Management economist, Ian Kernohan said: “The first Fed Funds hike since 2006, the first in a cycle since 2004 and the first that many finance professionals will have seen in their career, has finally arrived.  While we agree that the Fed will not want to frighten the horses and will stick to a gradual path initially, the market can often underestimate the pace of tightening in a rate cycle.

“If the labour market data remains robust through the rest of the winter, combined with a further rise in headline inflation, the market may have to revisit its benign view about the likely path of US interest rates. Bond markets would be most vulnerable to such a reappraisal, in particular government bonds, which have enjoyed a multi decade bull run of falling yields.”

M&G Investments head of institutional public debt portfolio management, David Lloyd warned there were three issues which could complicate the outcome of the announcement.

“The 25 basis points rise in US official rates was almost entirely expected, so the absence of any significant negative reaction in the markets is not overly surprising,” said Lloyd. “However, there are three issues, beyond the outlook for the real economy, that complicate things somewhat.

“Firstly, the state of the global economy – China in particular – has the capacity to affect the Fed’s future deliberations, particularly in the event that renewed weakness unfolds.

“Secondly, there is what we might call the asset economy. It seems likely that low rates will have caused some investors to take extra (and, perhaps, unfamiliar) risks in pursuit of yield. It will take some time before we will be in a position to assess the effect of higher rates on such decisions. The Fed will be watching closely.

“Thirdly, there is the tightening mechanism itself. Many analysts believe that the Fed will only be able to make the rate hike “stick” by withdrawing liquidity. Again, it will take time to observe and assess these issues, but any significant withdrawal of liquidity may well prompt bouts of market volatility.

“For pension funds, today’s events do not  –  yet  –  represent a watershed.  The prospect of modestly higher rates and government bond yields should come as a surprise to no-one.  For investment grade credit markets rate rises are, to an extent, a vote of confidence in the health of economies and, by extension, in the health of borrowers. Value is becoming increasingly apparent as credit spreads have widened recently. Clearly, High Yield is experiencing volatility but this is, of course, primarily caused by weak commodity prices.”

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