Those who routinely follow the markets must have noticed that most of the market commentaries nowadays make reference to market’s expectations around the first interest hike in the US. However, rather than discussing the merits or shortfalls of different forecasts I want to show why timing has such a great importance and how different the implications can be for different asset classes. Let’s take different scenarios.

Interest rate hike comes sooner than expected

In this case, because markets were not pricing-in such an early move, I would expect short term bond yields to spike as these are naturally highly sensitive to the central bank key rate (which is a very short term rate). 

1.1   Sooner and too soon

However, the reaction of longer term yields will hinge on whether the Fed can convince investors that the timing is right. If markets judge that the Fed rushed, their longer term growth expectations would likely be revised lower. This is because a premature monetary policy tightening can trigger an early end to the expansion cycle by increasing the cost of investments and mortgages before the demand momentum is strong enough.

In this scenario, longer term inflation expectations would also be downgraded and the end result would be stable or even lower long term government yields (i.e. price gains). Eventually, the yield curve could even become inverted (i.e. longer rates higher than the short rates). The equities would also suffer quite a setback as growth is key for supporting the current valuations; similarly, corporate bond spreads would widen (prices would fall).

1.2   Sooner but on time

Let’s now assume that Fed does the right thing by moving sooner than expected. The short term government yields would experience a similar weakness as they are precipitously adjusting to the reality of higher rates. However, the long term yields could also experience an increase (prices fall).  Corporate yields on the other hand would be broadly unchanged as the higher government yields would push them upwards but the credit spreads would decline as a stronger economy implies a lower default risk. For equities, valuations would find some support in the fact that growth is strengthening but the trend would likely lose some of its steam because margins are likely to have peaked. What is more, the higher yields could prompt some to shift out of equities and into bonds.

Interest rate hike comes later than expected

First, in this case the short term government yields will gradually increase and then start trading in a range as investors try to second guess when the long awaited move will come. Before the rate hike actually takes place we could see some weakness in equities and high yield bonds as investors would come to realize that growth is weaker than they had expected.

Once a decision is taken, whether markets are convinced or not that the timing is right, makes a big difference.

2.1   Later but not too late

In this case investors are likely to fear that the inflation will get out of control and a first consequence would be higher longer term government yields (lower prices). Short term rates could also spike as Fed could be forced to increase its rate repeatedly and at a higher pace to make up for the delay. In this environment, equities would likely outperform bonds but volatility is likely to be on the rise as judging the impact of the higher inflation on corporate profits is not a straightforward exercise.

2.2  Later but on time

In this case, the implications are largely similar to those of scenario 1.2. The only difference would be that the short term government yields would have already increased. By extension, corporate bonds with short to medium maturities would have already suffered a mild correction which would now be reversed as the risk of default is diminished by the confirmation that the economy is strengthening.

Interest rate hike comes when expected

In my opinion, the movements would be generally similar to those observed under scenario 2.2.

To conclude, for investors with medium to long term investment horizons the question should in my opinion be not so much if the interest rate hike will come sooner or later than expected but whether the timing will be right. The biggest exception is the portfolios skewed towards short term government yields.

Disclaimer:

This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.