Fed to Raise Rates After 7 Year Itch

Seven years to the day after the Federal Reserve lowered interest rates, the central bank is widely expected to bring to an end the era of zero rates in the US

Jeremy Beckwith 14 December, 2015 | 2:36PM
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On December 16 2008, the Federal Reserve established a target range for the Fed Funds rate of 0-0.25%. It said then that it expected to maintain low interest rates for an extended period of time. Not even they would have expected that target range to still be in place in 2015. 

The seven years of zero interest rates have been lucrative for investors in US financial markets, though not for savers

Seven years on to the day, on December 16 2015, following clear hints from several FOMC members, the Federal Reserve is widely expected to bring to an end the era of zero interest rates in the US.

It is certainly the case that the FOMC have been strongly hinting all year of a rate rise in 2015, but events, a weak US economy in H1, and generalised market weakness in Q3, following the decline in the renminbi, have delayed them to date. Now there is just one opportunity remaining.

It may be sheer coincidence but, biblically, seven is a number that indicates completeness. More prosaically, seven years is widely held to be the time at which many marriages start to struggle, and those involved think of change. Whether for reasons of completeness or boredom, the Fed seems keen to move.

The seven years of zero interest rates have been lucrative for investors in US financial markets, though not of course for those who prefer to keep their savings in cash. Many savers have been forced out of their preferred cash holdings and now hold investments in the bond and equity markets in order to seek some sort of return. As interest rates on cash savings are once again visible, the flows into financial market assets are likely to reverse. The tailwind of liquidity from US savers which has boosted market returns and taken valuations in all markets to historic highs, will become a headwind to returns and valuations will decline.

Changes in China Cause Middle East to Draw on Savings

At the same time as this reversal of liquidity, there is also a reversal of another key source of global market liquidity. Since 2000, the rise of sovereign wealth funds from Asian trade surpluses and oil exporting nations has been a key source of liquidity for financial markets as China and OPEC in particular have recycled their trade surpluses into the export of capital, most particularly into US government bills and bonds, but also more widely into global bond and equity markets.

In recent times, China’s desire to maintain a strong currency, or at least avoid being seen to have a weak currency, has meant that they have been reducing their holdings of US Government securities, quite probably in order to invest in gold, given recent disclosures of rising bullion holdings. As the Chinese economy has deteriorated there are increasing reports of entrepreneurs seeking to move capital abroad and out of renminbi, which have probably meant that to maintain a stable exchange rate, the state must have been buying renminbi and selling other currency holdings.

The collapse in the oil price over the last 18 months has seen dramatic effects on the fiscal positions of many Arab oil producing countries – for many years the Saudi government assumed $100 oil for its budget planning.

At a time of febrile regional politics, Arab governments cannot afford to bear down too heavily on the traditional government largesse to their own people. So, with revenues in freefall and expenditure steady, they have plugged the gap by drawing down from their sovereign wealth funds. The apocryphal rainy day has arrived. The leading investment management groups have been reporting significant mandate losses from the Middle East over the last twelve months as they drawdown on the rainy day savings.

Some have dubbed this reversal of flows from sovereign wealth funds as Quantitative Tightening – it certainly has a similar effect as the reversal of central bank QE would have. With this, as well as rising US interest rates, the liquidity available for investment in financial markets is now falling after seven years moving higher. This is not a good backdrop for the performance of markets in 2016.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Jeremy Beckwith  is Director of Manager Research for Morningstar UK

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