The Fed has finally moved interest rates up from their historic lows. Market reaction has been muted, since the much-trailed hike was fully priced in across asset classes. But attention will now shift to the pace and timing of further tightening, which will create further market instability in 2016
As we had expected, the Fed raised short-term interest rates for the first time in almost a decade, increasing the target range for the federal funds rate by 25 basis points to 0.25-0.50%.
The focus will now move to what comes next. We expect the pace of tightening to be very gradual, with only a further two 25-basis point increases in 2016, taking the target range to 0.75-1.00% by the end of the year. This is a slower than the consensus, which is for three rate rises in the coming year. We think that tightening monetary conditions as a result of a stronger dollar and widening corporate bond spreads will deter the Fed from moving more aggressively.
Moreover, the Fed has stressed that policy remains data-dependent, and that it will pay particular attention to inflation as measured by PCE (personal consumption expenditure). This is currently at just 1.3%, well below the 2% target. The evolution of US inflation in the coming year will be a key variable for markets.
Policy divergence is reinforced
Monetary policy will therefore remain very accommodative, with interest rates well below nominal GDP growth, as the Fed seeks to maintain favourable financing conditions and support economic growth. However, its effectiveness in this respect will be weakened by the imbalances created by the desynchronisation of the monetary policies of the main central banks. Developments in December have reinforced the divergence between the Fed and the ECB, with the latter taking rates further into negative territory and announcing an extension of QE. One result is that, although the USD bull trend is largely played out, we expect the dollar to strengthen further in 2016.
The immediate impact of the Fed’s tightening on markets has been very limited, since the ‘dovish hike’ was widely anticipated, and fully priced in across asset classes. This was a factor in the recent widening of corporate bond spreads, notably in US high-yield, and further monetary tightening will continue to push up spreads during 2016.
Our core scenario for the coming year remains unchanged. Tighter monetary conditions will contribute to a lack of momentum in US economic growth, which we project at 2.3% in 2016, little changed from an estimated 2.5% in 2016. Given an absence of momentum in economic growth and corporate earnings growth (which we expect at just 5% in 2016 for the S&P 500), as well as stretched valuations, returns potential for developed equity markets will be limited, to around 7-10% (including dividends). European equities are likely to outperform US equities, since economic recovery in the euro area is less advanced and monetary policy is more supportive.
Diversification will remain highly important
Uncertainty over the timing and magnitude of Fed tightening, combined with the imbalances created by the desynchronisation of central bank policies, means that volatility on financial markets will increase in 2016. Robust diversification will therefore remain highly important.
We expect a gradual rise in rates on 10-year US Treasuries to 2.7% by the end of 2016, as monetary policy tightens. However, US Treasuries will likely remain attractive to protect portfolios against shocks to equity markets. Although the Fed’s historic rate rise looks to have passed off smoothly, the calm on markets is unlikely to last for long.
Christophe Donay, head of Asset Allocation & Macro Research Pictet Wealth Management