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Investors: Prepare for Fed Rate Rise in June

The Federal Reserve raised interest rates for the first time in seven years last December but has since put further rises on hiatus. Consensus suggests June or July is the next hike

Emma Wall 26 May, 2016 | 10:47AM
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Emma Wall: Hello and welcome to the Morningstar Series "Market Reaction". I'm Emma Wall and I'm joined today by Kevin O'Nolan from Fidelity.

Hi Kevin.

Kevin O'Nolan: Hi.

Wall: So in December the Federal Reserve raised rates the first time in seven years and at the time everyone was very enthusiastic and they predicted that 2016 would see four rate rises. This hasn’t happened. Why is everyone so much more gloomy about the prospect now?

O'Nolan: When we came into 2016 and immediately there was quite considerable financial market volatility. Really centered on China. So the currency weakened for the second time in six months and that really rattled markets. At the same time growth data was coming in a little bit weaker. I think this was really what was concerning the Fed. It was whether or not that weakness in EM was going to feed over into some of the measures that they look at U.S. inflation and U.S. growth. And it just meant that they wanted to pause for little bit. I think it was quite sensible and I think what we have seen in the last few weeks is better data and better markets.

Wall: So fast forwarding six months we're now in May and lot of people are saying that June, July we are going to have another rate rise. That seems to be the consensus view, would you agree with that and what's happened I think you alluded to it then to make people think another rate rise is coming.

O'Nolan: I think it's high probability at this stage. I think that unemployment data has continued to be pretty much at target for the Fed. What we have seen is that inflation data has started to pick up for the first time early in a couple of years. At the same time those two things that I pointed out in terms of what was weak in Q1, so growth and also financial markets have improved. So the Fed have clearly looked at the way that markets are pricing and said that we need to bring back in this prospect of summer rate hike.

So the April Fed minutes showed that June has a real possibility and in speeches by Fed governors and Fed Board members in the last couple of weeks they've continued to confirm that. Over the next 10 days we've got some key data points in terms of core inflation. We've also got May business confidence and the May jobs report. I think if those three reports continue on their recent trend I think Janet Yellen is likely to hint at her speech on 6th of June that they are likely to raise rates.

Wall: Okay. So let's say we do have that positive trajectory, all the planets align and Fed raises rates either in June or July. What does that mean for investors?

O'Nolan: The most obvious impact is in fixed income. So I think it means higher bond yields, but sort of taking a step further I think one of the key beneficiaries over the last few years has been a stronger dollar. So because the Fed is the only major central bank tightening policy, the dollar has been quite strong. And I would expect that trend to continue.

Similarly, it’s a negative for emerging markets. I mean it puts downward pressure on emerging market equities. For the broader equity markets the jury is still out I think. What we have seen in previous tightening periods is that equities can continue to do quite well. But most of the returns come from earnings rather than from ratings. So really it’s a question of whether or not earnings can bounce back from here and if that is the case then I think equities can do quite well.

Wall: Kevin thank you very much. This is Emma Wall for Morningstar. Thank you for watching.

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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Emma Wall  is former Senior International Editor for Morningstar