Anticipation builds over Fed interest rate increase

Aug 19th, 2015 | By | Category: Fixed Income

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ETF investors continue to monitor for signs that the Federal Reserve will increase base interest rates sometime this year, apprehensive of the effect it could have on the values of asset prices, particularly in bonds markets. As Dodd Kittsley, Head of ETF Strategy at Deutsche Asset & Wealth Management, explains: “Arguably at no other time in recent history has the institution (the Federal Reserve) held the sort of influence over markets and the economy than it does today.”

Anticipation of a rate rise increases as Federal Open Market Committee meeting commences

Janet Yellen, Chairwoman of the Federal Reserve.

Those trying to decipher the code of when the increase will occur may consider a June survey of Federal Reserve officials as a further piece to the puzzle. The 17 officials (five board members and twelve reserve bank presidents) were polled regarding their expectations for the prevailing federal funds rate target over the upcoming years.

For 2015, expectations were clustered within the range of 0.25%-0.75%, producing a median expectation of 0.625%, thereby indicating two interest rate hikes during the remainder of the year.

From 2016 however, the range was more widely dispersed between 0.375% and 2.875%, showing increased concentration of expectations around 1.5%.

The distribution range remained wide for 2017 but had shifted upwards to between 2% and 3.875%. Over the long run, however, expectations became more narrowly concentrated around a smaller range between 3.25%-4.25%.

How may one interpret these results?

Firstly, consensus from all officials is that rates will increase at least once this year during the remaining meetings of the Federal Open Market Committee (FOMC), scheduled for 16-17 September, 27-28 October, and 15-16 December. Secondly, at least half of the officials expect two rate increases during the year. Lastly, although there is considerable difference of opinions as to the specific rate level going forward, all members appear to agree that the Fed will likely incrementally raise rates several times over the upcoming years, marking a definite shift away from the long-standing near-zero interest rate environment.

At the meetings the members will analyse huge swathes of data; however, primary focus will be on the GDP growth rate, inflation, and unemployment.

GDP growth has rebounded since the recession took hold in 2008, with Deutsche Asset & Wealth Management citing an estimated GDP growth rate of 2.4% for 2015, further growing to 3.1% in 2016. Janet Yellen, Chairwoman of the Federal Reserve, dismissed weak GDP growth statistics for Q1 2015 (the economy actually contracted by 0.2% according to the US Bureau of Economic Analysis), pointing to the fact that Q1 results have historically underperformed other quarters by 1.0%-1.5%. She further stressed the effect that unique circumstances such as labour strikes at ports along the west coast, as well as a particularly harsh winter, had on that result.

Inflation, according to the Fed’s preferred indicator, the Personal Consumption Expenditure Index (PCE), is slightly above zero, and certainly not accelerating to levels which would induce a rate rise from the Fed. The sudden sharp drop in the index during 2014 casts light on an underlying cause though: tumbling oil prices and a general slump in imported commodities has kept the index depressed. Core PCE, negating the effects of food and energy prices, is actually hovering just below 1.5%, not too far from the Federal Reserve target of 2%.

The unemployment rate of 5.3%, bordering the stated long-run natural unemployment rate of 5.0%-5.2% and considerably below the high of 10.0% recorded in October 2009, provides the most compelling case for a rate increase. During her semi-annual testimony to Congress in July, Janet Yellen acknowledged the robustness of the labour market but insisted further improvement was possible.

The market remains undecided as to the timing of the first rate increase with even Nobel prize-winning economists, Paul Krugman and Edmund Phelps, holding conflicting views.

Krugman supports the notion of a delayed rise in rates, highlighting the asymmetrical risks of mistiming the move : “If the Fed waits too long  to raise rates, then we get a little bit of inflation. If the Fed raises rates too soon we risk getting caught in another lost decade.”

Phelps however, argues that a rise in rates is more imminent, suggesting that the Fed will not wish to risk delaying too long as this may signal to market participants a lack of faith in the economy. Indeed, a rise in rates when it does come, will surely provide a psychological boost, considering rates have been at historically low levels since December 2008.

The recent devaluation of China’s currency sent shock waves throughout the world and across various asset classes. One of the likely consequences is a slowdown in the world economy, prompting less inflationary pressure in the US. This will cause the FOMC to re-evaluate the timing of its first interest rate hike, likely pushing the chosen date to at least December, if not sometime next year.

Indeed, the market appears to only expect a small rate increase right at year-end as evidenced by the Federal Funds Futures market. Current prices highlight an expected rate of 0.325% for December indicating the view that rates may move once this year. Interestingly, the implied rate for November is 0.27%, demonstrating a consensus that the first rise will only take place at the final meeting of the year.

ETFs tracking US mid-cap firms may be poised to benefit from the rise in interest rates. A rising rate environment signals to investors that the economy is performing well, and medium sized firms often benefit due to the majority of their business being within the country. Large-caps generally have significant overseas operations, diluting the effect of rising profits on their home turf. Small-cap companies may perform well but carry their own set of risks.

There may be a delay to this benefit though. The previous period of unmatched monetary stimulus and persistent low rates have left investors unsure of the reaction of the economy when rates begin to increase. Most likely, portfolio managers will test the waters slowly before shifting large positions into equities.

The SPDR S&P 400 US Mid Cap UCITS ETF (SPY4 LN) offers investors exposure to medium sized US firms by tracking the S&P Mid Cap 400 Index. The fund is well diversified and, as of 18 August 2015, had significant exposure to financials (25.8%), information technology (15.6%), industrials (15.3%), consumer discretionary (13.7%) and healthcare industries (9.7%).  The total expense ratio is 0.30%.

Investors looking for exposure to the US equity market but concerned that an increasingly strong dollar, likely to be boosted when the Fed increases rates, would negatively impact exporting firms, may wish to consider the WisdomTree Strong Dollar US Equity Fund (USSD). The fund only includes companies with significant revenues (over 80%) generated within the US. Further to this, the fund weights its final constituents based on the historic correlation between the return of the firm and the return on the US Federal Reserve Trade-Weighted Dollar Index, favouring those firms with higher correlations.

This fund, which trades on the NYSE Arca in US dollars and has a total expense ratio of 0.33%, is highly diversified with 269 holdings of which the top holdings as of 18 August 2015 include Verizon (1.5%), AT&T (1.4%) and Comcast (1.1%). The fund has significant exposure to the financial sector (24.9%), followed by the consumer discretionary (20.3%), utilities (14.6%), industrials (10.6%) and healthcare (10.2%) sectors.

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