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US rate rise causes market carnage

US rate rise causes market carnage

The decision by the board of the US Federal Reserve to raise interest rates by 0.25 per cent has prompted a sharp sell off in US equities.

The market dropped by 2.5 per cent yesterday (December 19) in the immediate aftermath of the announcement, before closing down 1.5 per cent.

Share prices often fall when interest rates rise.

This is because higher interest rates means higher returns from cash, making the dividend income received from shares less attractive relative to owning cash, so investors sell the equities.

Those shares that pay no, or meagre, dividends suffer most in such a scenario.

The largest US technology companies have been among the sharpest fallers during the recent market turbulence as they are not major dividend payers.

Higher interest rates also dent demand for equities because borrowing costs rise, and consumers and businesses that must pay more to service debt, have less cash left to spend.

This reduces the level of demand in the economy and so companies sell fewer products, and have lesser profits.

In bond markets, the price of the US 10-year government bond rose, with the yield falling below 3 per cent for the first time in months.

As the 10-year US government bond is typically viewed as a safe haven asset, the rise in its price implies that the market believes the interest rate rise was not justified, and will lead to a slower pace of economic growth.

If the market believed the economy was strong enough to shrug off the effects of this interest rate rise, then it would sell, rather than buy, the US government bond.

This is because, if the economy were strong enough to withstand higher rates, inflation would continue to rise, and so more interest rate rises would happen.

Melanie Baker, senior economist at Royal London Asset Management, said: "More cautious signal from the Fed could have been justified (and would have been welcomed by equity markets) given the tightening in financial conditions and weaker global growth backdrop.

"However, the domestic economic data has looked strong enough to suggest that we aren't at the peak of the rate cycle quite yet."

Kuly Samra, vice president at Charles Schwaab, said the economic backdrop in the US is uncertain and may prompt the US Federal Reserve to put rates up by less than it presently indicates it will.  

david.thorpe@ft.com