The US Federal Reserve (Fed) is on track to end its quantitative easing program in October. As a result, investor attention is turning towards speculation over when US interest rates will start to rise.
The story so far…
- After sharp interest rate cuts by the Fed at the outset of the global financial crisis, quantitative easing (QE) began in November 2008 with the Fed buying US$1.25 trillion of mortgage-backed securities and $175 billion of agency debt in order to boost money supply.
- With few signs the US economy was recovering the Fed embarked on a second program of bond purchases, buying US$600 billion of longer-term US Treasury securities from November 2010.
- The third round of quantitative easing commenced in September 2012 and involved the Fed purchasing agency mortgage-backed securities. The targeted total value and timeframe were open-ended and initially involved purchases totalling US$40 billion per month which grew to US$85 billion per month.
- With the US economy showing signs of stabilising, the Fed announced in June 2013 that it planned to begin tapering its bond-purchasing program – with the value of bonds purchased to be gradually reduced in accordance with how the recovery was progressing.
- This tapering commenced in December 2013, and saw monthly bond purchases gradually decrease to the current level of US$15 billion per month.
Update on QE tapering and the outlook for interest rates
On the one hand, the US economy has improved enough to allow the Fed to continue tapering its quantitative easing program throughout 2014 without causing too many dramatic disturbances in investment markets. On the other hand, it’s unclear that conditions are strong enough to warrant interest rate hikes just yet. This is something the Fed is grappling with, but the conclusion seems to be that – with inflation and wages growth at low levels and excess capacity in the labour market remaining – the Fed is unlikely to rush into raising rates.
The Fed currently states that it anticipates a ‘considerable time’ between the ending of quantitative easing and the first rate hike, with this taken to mean six months or more. With quantitative easing ending in October, we expect the first rate hike is likely to be in the June quarter of 2015.
What does this mean for investment markets?
With quantitative easing ending in the US and interest rate rises on the cards within the next 12 months, implications across each asset class vary.
- Equities: The experience around the initial flagging of tapering last year which saw shares fall 5-10% warns of the risk of a correction in the run up to and/or in response to the first rate hike. But beyond a short-term upset, the initial monetary tightening is unlikely to be a huge problem for shares. Historical experience tells us that the start of a monetary tightening cycle is not necessarily bad for shares. This is because in the early phases of a tightening cycle, higher interest rates reflect stronger economic and profit growth. It’s only as rates rise to prohibitive levels that suppress inflation that it becomes a problem.
- Fixed income: The commencement of a monetary tightening cycle in the US is expected to put upwards pressure on US and global bond yields in response to the uncertainty as to how high rates will ultimately go. A 1994-style bond crash is a risk but is unlikely – as the more constrained US and global growth and inflation backdrop this time around will likely mean that the monetary tightening cycle will be more gradual than in 1994.
- Real estate: Higher longer-term bond yields will likely make the relative yield from real estate slightly less attractive. As one of the beneficiaries of the reach for yield in the absence of attractive yields being offered by bonds, direct and listed real estate is vulnerable to a sharp rise in bond yields should it occur.
- Australian dollar: Progress towards eventual rate hikes in the US will put further downwards pressure on the Australian dollar.
Generally speaking, the end of quantitative easing and eventual US interest rate increases should be viewed by all investors as a good sign – after six years the US economic recovery is well underway and solid enough to withstand the start to more normal monetary conditions.
While uncertainty regarding the timing and magnitude of US interest rate increases is likely to keep flaring up periodically, on balance the move is a positive indicator as it signifies a brighter long-term outlook for the US economy (and therefore investors).
The fact that each assets class will be impacted in a differing way – and to a differing extent – is a timely reminder of the importance of maintaining a well-diversified portfolio.