Kames Capital: Why the Fed’s rate decision this week isn’t the whole story

Ahead of the US Federal Reserve’s meeting on Wednesday this week, Adrian Hull, fixed income product specialist at Kames Capital, comments:
“At 7pm on Wednesday evening the market expects to see the end of the Federal Reserve’s “Zero Interest rate policy”. Fed funds rate was set at 0%- 0.25% at the same meeting in 2008 – an unprecedented 7 years of unchanged, emergency rates and almost 10 years since a rate hike. The market has priced an 80% likelihood of Fed funds moving to 0.5% – probably the most talked about event that hasn’t happened over the past three odd years. Indeed, so totemic is this move that investors run the risk of forgetting all the other things that really drive the economy.
“Up until September’s meeting despite a weaker global outlook the market’s estimation has been that after the first US rate hike there would be more – with the expectation that rates would rise by 1% in total in the subsequent 12 months.  In thinking about what this rate cycle is likely to bring there has been far more reflection on previous cycles. Since the early 1980’s rate cycles have seen Fed funds raised by 2.75% on average; over those 6 cycles all asset classes have increased in value – from commodities, equities through to and including government bonds. Shorter government bonds move higher in yields, longer government bonds less so – flatter curves have emerged. Each cycle has different dynamics – and this time it is no different.
“Since the start of 2015 two year UST have more than doubled in yield from 42bps to 95bps -underperforming 30 year yields by 50bps; corporate bond spreads have widened by more than 30bps. Commodities have collapsed in 2015, equities struggled. The value of the $ has appreciated by almost 10% as measured by the trade weighted $. And as importantly expectations of further rate rises are muted. Fed funds are only pricing in a further two rate hikes for 2016 – very different from the trajectory of the 1994 and 2004-2006 rate cycles. The market in many measures is ahead of Fed policy. Fed funds are not the whole story when it comes to evaluating the cost of funds to the real economy.”