By David Lloyd
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. The accompanying statement contained no meaningful revisions to earlier economic forecasts, nor to the expected future course of rates. So far, so benign.
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. Similarly, some players may have taken advantage of minimal rates to increase borrowing (leverage). 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.
David Lloyd is head of institutional public debt portfolio management at M&G Investments
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