What will be the outcome of the US Federal Reserve’s delicate balancing act when the FOMC makes its latest announcement; should markets prepare for a race to raise interest rates?
What we know so far
Unprecedented low interest rates and monetary stimulus have helped stock markets, particularly in the US, hit record highs as investors sought higher returns. The policy of keeping rates low has helped suppress the yield in other asset classes such as the bonds and foreign exchange.
This is unlikely to continue.
A delicate balancing act
Eventually interest rates will begin to rise and the world is likely to return to a new normality. But the Federal Reserve is playing a delicate balancing act. On the one hand, the US is experiencing exceptional job growth - February's forecast-beating US jobs data stoked expectations the Fed would raise interest rates sooner. In normal circumstances this would automatically lead to an interest rate hike – but these aren't normal times.
On the other hand, the US must balance an improving economy and employment with low wage growth – which highlights ongoing uncertainty from employers about the strength of the recovery – and low inflation, which has been subdued by the recent collapse in the oil price. Jobs growth and an improving economy would normally trigger a rise in inflation, but this doesn't appear to be happening. CPI inflation fell by 0.7% to -0.1% in January, largely due to falling petrol prices.
Intense speculation over when the Federal Reserve will hike rates has seen the US dollar rip higher against the euro.
Yellen's shock absorbers
Janet Yellen, the Fed chair, has been preparing the ground for a rate rise for many months in an attempt to ease the "shock" of a rate rise (which would be its first in nearly a decade). Despite the low inflation, markets are still pricing in a rate rise in the US for mid-2015 - at which point we shall find out how effective the Fed's communication will have been and what impact this will have on assets.
The outlook for some assets
In normal circumstances a rise in interest rates would trigger a rise in yields and fall in bond prices, but because the Fed has all but flagged a rate rise occurring it is hoped that this won't necessarily be the case.
It is expected that demand for US bonds should remain strong given economic issues in the Eurozone. Provided that the Fed does not begin to sell down the position it holds in US debt as a result of quantitative easing, there is unlikely to be huge selling pressure in US bond markets.
Abandoned by investors for the best part of the last decade foreign exchange markets have livened up in the last year as a result of anticipated rises in interest rates. Already the US dollar has hit recent record highs against a basket of major currencies on expectations that the US will beat the rest of the world's major economies in raising its interest rates.
Equities has been the asset class which has benefitted the most from economic stimulus, so obviously they could experience some volatility as rates rise and investors potentially switch their asset preferences. Whether we will see an equity correction remains to be seen. While rates are on the rise, yields in equities remain attractive.
The truth is no one is entirely sure what will happen when the Fed begins to raise interest rates. The stimulus measures undertaken by the US and global governments after the credit crunch in 2008 has been unprecedented, therefore the true effect it will have on markets and the economy will be unknown until it actually happens. This could either send traders hunting for protection products or provide the volatility that will lead to a bout of trading activity.