It was no surprise to markets when the US Federal Reserve lifted the cash rate by 0.25 per cent on 16 December 2015, the first time the cash rate had risen for a decade.
While the news was positive in the short-term, at least for equities markets (the All Ordinaries was trading at 5078.4 points on 16 December 2015 and was at 5048 points by 30 January 2016) incremental increases to the US cash rate will have long-term consequences for the Australian and, indeed, the global economy.
As a business leader, it is worth understanding how this move by the Federal Reserve will impact economic conditions in the longer term.
The fact the share market rallied on the rate rise is a positive sign. In fact, share market traders had long anticipated this move, which had been priced into equity markets many months earlier. This explains why the market reacted positively. It also explains why the Federal Reserve had spent so long priming the market for the rate rise.
Share markets hate surprises and traders would have reacted negatively had the Federal Reserve moved to change the rate in an unexpected fashion. This would have been unlikely given that the Federal Reserve understands only too well about the consequences of changing policy without first flagging it with investors. It learned its lesson in 2013 when it reduced its quantitative easing program without giving the market fair warning.
This resulted in havoc on markets. The US started tapering its quantitative easing program on 19 June 2013. On 14 June 2013 the Dow Jones Industrial Average, the main US share market, was trading at 15,070 points. By 21 June 2013 it was down to 14,799. As such, the Federal Reserve knew it had to take a soft approach to its most recent interest rate rise, and to any subsequent rises.
Coming back to the US’s decision to lift interest rates in December last year, it’s important for CFOs to understand how this will impact the various asset classes in the near term and into the future.
When interest rates rise, the outlook for cash also improves. This is because the return investors can expect increases with the rate rise. This is good news for CFOs with cash in the bank because it means the rate of return on this money should improve.
It seems common sense to assume that when interest rates rise, so too should the value of bonds. But actually, the value of bonds tend to drop when rates rise. Expect the value of fixed interest investments such as bonds to continue to fall should rates in the US continue to rise, as they are expected to. CFOs with bonds in their business’ investment portfolio might need to consider this dynamic when re-weighting the portfolio. CFOs issuing bonds will also have to offer investors a higher rate of return as interest rates rise, which means borrowing costs will rise.
Property values generally experience a decline when interest rates fall. This is because borrowing costs on property assets tend to increase when interest rates rise. CFOs whose businesses have substantial property assets will need to consider how the value of the portfolio will change. However, the rate rise won’t have a material effect on rental yields in the short-term given most commercial leases are long-term in nature and therefore locked in over a period of years. Rental yields however coulddrop longer term in line with declining property values.
Official interest rate rises have a reasonably complex effect on share markets. While the recent US rate rise signalled increasing confidence in the economy among policymakers, which led to a short-term rise in market values, longer term the effect is different. Interest rate rises tend to increase companies’ borrowing costs and, therefore, potentially have a negative impact on markets.
Higher US interest rates in an environment in which the Reserve Bank of Australia (RBA) maintains interest rates at current levels is positive for certain sectors. This is because the lift to the US rate leads to a lower Australian dollar, given the relative attractiveness in the interest rate differential between the US and Australia. This means that sectors, which benefit from a low dollar, for instance tourism, where a lower dollar makes it comparatively cheaper for overseas visitors to holiday in Australia, may see an uptick in performance, which will be reflected in the share prices of publically listed businesses in these areas.
One of the unknown factorsis the likely attitude of the RBA to the cash rate as the US continues a program of gradual increases to interest rates.
Commenting in the Australian Financial Review in December 2015, Reserve Bank Governor Glenn Stevens said, "My own feeling has been if you think things are shaping up to deliver an improvement, let's see how that goes for a while, and we still have some firepower to use if it makes sense."
Stevens made this statement before the share market experienced a significant drop at the start of 2016. So it’s likely his perspective, alongside that of his board member colleagues, has changed since he made that statement. The market won’t get an indication of the RBA’s approach to the direction of future interest rate movements until the board meets on 2 February 2016.
It’s also worth considering the US’s approach to future interest rate rises in that market, in light of recent share market volatility. CEO, Eric Rosengren, one of the board members of the US Federal Reserve and Bank of Boston President has indicated any further rate rise would need to be predicated on clear evidence the US economic recovery is sustainable. In light of ongoing volatility in China, and the potential this has to derail the US’ economic recovery, this seems unlikely in the short term.
Asset class impacts as US interest rates rise:
- Cash: positive
- Bonds: negative
- Property: negative
- Equities: positive and negative