Atrophy alert

16 December 2015 By Richard Beales

The Federal Reserve has finally done it. The U.S. central bank’s rate-setting committee on Wednesday lifted the target range for overnight rates by a quarter point to 0.25 percent to 0.5 percent. It’s the first time it has established a non-zero cost of borrowing since the crisis days of December 2008, and the first rate hike in nearly a decade. Though it was overdue and universally expected, the new direction may still create fresh uncertainty.

It has been seven years since anyone’s overnight rate muscles have been used, and there may be some atrophy. Asset owners and managers may think they’re prepared, but interest-rate risk could cause twinges in unexpected places – especially if it is accompanied by a turn in the credit cycle for U.S. borrowers, something recent junk-bond market volatility suggests could be happening.

Expectations for the future could change, too. Relief that the Fed under Chair Janet Yellen has finally lifted off will surely be widespread, but for some, only now will attention really turn to what happens next. With the divergence between U.S. and European central bank monetary policy officially confirmed, the dollar could strengthen further, for example.

Longer-term rates could increase in sympathy with the short end of the yield curve. Or they might slip lower if traders think the Fed’s new, gentle path towards higher rates will defer any inflationary pressure and slow GDP growth, which ran a modest 2.2 percent year-on-year in the third quarter, according to the Bureau of Economic Analysis.

Then there’s the Fed’s ongoing policy. Will Yellen and her Federal Open Market Committee colleagues now go slowly, perhaps raising rates by a quarter of a point at every other one of 2016’s eight scheduled meetings? Or is a more frequent pattern of smaller increases the likelihood? The Fed will say its decisions are data driven – but which data points now matter?

Getting out of the zero-rate armchair was overdue, and many in the market will be glad it has finally happened. But it will provoke new questions with uncertain answers. Relearning how to climb the rate stairs could involve market stumbles.

 

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