What a pause in US rate rises means for investors

Although rates were lifted by 0.25 per cent to 5.25 per cent, and this is the highest level for sixteen years, the language accompanying the announcement was taken by the market to imply that further rate rises are unlikely. 

Susan Hill, senior vice president at Federated Hermes, says: “A contextual change in the FOMC post-meeting statement hinted strongly that policymakers are content to move to the side-lines for a while.

"Out was the March statement’s sentence: 'The Committee anticipates that some additional policy firming may be appropriate'.

Powell’s comments left markets exuberant, perhaps too much.George Lagarias, Mazars

"In was the statement: 'In determining the extent to which additional policy firming may be appropriate to return inflation to 2 per cent over time'.”

Chairperson Jerome Powell said the decision to pause had not been made but emphasised that policy action at the upcoming meeting in June would be more data dependent than ever.

Hill adds: "This is the appropriate stance. Until the economic impact of tighter credit conditions resulting from the March banking sector stresses is better understood, taking a breather is warranted."

George Lagarias, chief economist at Mazars says that even if rate rises are paused from here, this is almost “irrelevant” because the current peripatetic banking crisis in the US has much the same impact on financial markets and the economy as rate rises.

This is because, as liquidity declines in the economy, commercial banks rein in their lending, or charge more in interest, and also potentially pay out more in interest to depositors, all of which actions serve to shrink the money supply. 

Lagarias says: “Powell’s comments left markets exuberant, perhaps too much. The Fed chairperson hinted at a pause, without directly promising one.

"Yet investors cheered the end of rate hikes altogether. Bond market movements are now suggesting zero rate hikes from here on and no less than four rate cuts by January.

"Perhaps we have reached the end of the rate hike cycle, or perhaps we have a few more yards to go. At this point, it is almost irrelevant.

"Financial conditions will continue to tighten for some time, due to the combination of high interest rates and increased banking stress in the US."

Profound impact

But Hugh Grieves, who jointly runs the US Opportunities fund at Premier Miton with Nick Ford, believes the comments on chairperson Powell can have a profound impact on market.

Speaking in the context of the latest US jobs data showing unemployment is actually lower now, at 3.4 per cent, than it was on the day rates began to rise, he says the signal from the Federal Reserve means investors are now happy to view positive economic data as being good news.

Previously, positive data was interpreted as meaning that interest rates would have to rise still further in order to slow the economy and curtail inflation. 

Neil Birrell, chief investment officer at Premier Miton, agrees that the latest communication from the Federal Reserve sends a signal that would boost sentiment among investors who with a higher tolerance for risk. 

Daniele Antonucci, chief economist & macro strategist, at Quintet Private Bank agrees that rates may not rise from here, in his view the issues with the US banking system have prompted the pause, as they have the same impact as a rate rise. 

The other problem for policy makers is that lifting interest rates could exacerbate the issues in the banking system, as higher rates might be expected to push down the capital value of long dated bonds. 

As many banks hold a meaningful portion of their assets in just such long dated assets, a collapse in price impacts their solvency immediately. 

Halting or cutting? 

But halting further rate rises is a different scenario than actually cutting rates from here, according to Gabriele Foa, manager of the Global Credit Opportunities fund at Algebris Investments.

His view is that further rate rises are more likely than rate cuts right now, though his main expectation is that rates won’t change at all until the end of this year at least. 

The extent to which markets are already investing as though rate cuts are inevitable is illustrated by Charles Hepworth, an investment director at GAM, who says that in his opinion asset prices presently reflect the possibility of two rate cuts this year.

Hepworth’s view is that economic conditions may deteriorate in the US in the coming months and that may force the Federal Reserve to cut interest rates. 

Markets in recent months have been in a tug-of-war between buying bank stocks, if they thought rates would rise, and and buying tech stocks if they thought rates would not rise.Steven Andrew, M&G

Salman Ahmed, global head of macro and strategic asset allocation at Fidelity, takes a similar view, arguing that while the Federal Reserve will need to communicate as though no rate cuts are coming as inflation remains above target, but Ahmed believes that a minor recession “remains the high likelihood scenario.”

Steven Andrew, a multi-asset fund manager at M&G, says markets have stopped fixating on the interest rate and inflation policy.

In part, this because investors feel the deterioration in credit conditions resulting from the stresses in the US banking system that have already happened, has had the same impact as higher rates would. 

He says credit growth has essentially stopped, and that is something which typically only occurs when a recession has already happened. 

With that in mind, he is reluctant to make major asset allocation calls right now, saying investors need to be "circumspect" about the level of uncertainty in markets. 

One of the reasons economies have performed better than expected in recent months is that while the quantity of money in the economy has shrunk, the velocity of money, which is the other side of the MV=PT equation that underlines modern economic theory, has continued to expand. 

Conventional theory implies that if interest rates rise, then the velocity of money should shrink because higher rates of interest reward the holding of cash by individuals and banks. 

Andrew says we are probably now at the tipping point where the velocity of money will start to shrink, presaging the downturn that is to come.  

Investment implications 

Whitney Watson, global co-chief investment officer for fixed income and liquidity at Goldman Sachs Asset Management, says the US economy is slowing, but proving to be “resilient” so far.

With this in mind, she believes markets may be wrong to be pricing in a cut in rates for later this year.

Her view is that the potential for economic uncertainty justifies owning bonds with a high credit rating as those are likely to be best able to cope with higher volatility. 

Chris Iggo, chief investment officer for Core at Axa Investment Managers, says that if the Federal Reserve really have paused rate rises then one of the asset classes which looks attractive in consequence is corporate bonds. 

He feels they spread on these assets, that is, the yield offered above that of government bonds is presently attractive.

If rates rise again, then the likelihood is that government bond yields would rise, reducing the spread, while higher interest rates would also be expected to slow down the level of economic activity, potentially making it more difficult for companies to pay the investors who own their bonds. 

But if rate rises are paused, that may also be seen to signify that a recession is near, and drive up the price of the government bonds, which drives the yields on those assets downwards, and potentially preserves the spread over corporate bonds. 

M&G's Andrew adds: "If US rate rises do stop now, then that will be good for tech shares.

"Markets in recent months have been in a tug-of-war between buying bank stocks, if they thought rates would rise, and and buying tech stocks if they thought rates would not rise."

david.thorpe@ft.com