US rate rise: The first step in a long march

Scott Jamieson, head of multi-asset at Kames Capital, analyses the impact of the US rate hike on the rest of the world.
Just as we discovered on the 1^st of January 2000, the world didn’t end after the US Federal Reserve raised its policy rate for the first time in nearly a decade – after all, even a visiting Martian would have been aware that it was coming. Though its timing (combining with seasonal illiquidity) had the potential to spawn exaggerated market moves, the dominant market reaction has been, right, let’s do Christmas.
Ahead of the event there was a strong belief that the Fed would cushion the blow by describing a still cautious outlook – they would deliver the so-called ‘soft hike’. In the end the Fed barely shaved anything off their year-end policy rate forecasts for 2016-2018 (reflecting a slightly softer outlook for inflation) and kept their long run policy rate at 3.5%. Such a rate may be below historical experience but is substantially higher than anything forecast for the likes of Europe and Japan.
In the years since the Great Financial Crisis, both policymakers and markets have been far too optimistic about the profile of future interest rates. Learning from this, traders remain sceptical about whether the Fed will ever be able to deliver on those forecasts and are fully 1% below for end 2018.
This more confident Fed will hope to be supported by a more resilient economy in the first quarter than has often been the case in recent years – cold weather shocks aren’t in prospect. A second hike late in Q1 then looks to be on the cards and this would draw the market closer to the Fed’s trajectory.
The US dollar is likely to be the major beneficiary of such a move (in fact and in prospect). A strong dollar is clearly not something new but with international interest rate differentials widening, and without an obviously better destination for American investment dollars than the home market, further strength seems inevitable.
Previously countries like China would have been major beneficiaries but it has its own problems – and its own currency agenda. Earlier this year the Chinese surprised everyone by lifting the peg rate to the US dollar; markets came around to the view that further weakness would be very gradual even after SDR status was secured for the Renminbi.
Not so it seems. 2015 has already seen an exodus of domestic capital worth around $1trillion and, as a deterrent, the authorities are allowing the Renminbi to fall afresh. If this continues at the same pace the impact on the global economy will be significant, and the Fed’s benign backdrop will quickly disappear.
The US is trying to pull away from the rest of the world, but the rest of the world won’t let it go.