US rate hike the lesser of two evils

While most investors reckon that the US Federal Reserve will hold off on an interest rate hike until December 2015, François Savary, Chief Strategist of Reyl & Cie, still thinks it likely that the Fed could make a move in September.

The US rate increase question is important in several regards. Firstly, because it will be the first such hike in some eight years. And second, the shift in monetary policy direction would stand as the best possible proof that we have entered the second phase of the economic and financial cycle that began in 2009.

But a US rate increase will also be a journey into unchartered territory. While the introduction of unconventional monetary policies may have been a novelty back in 2008, the last few years have accustomed us to living with the effects of massive injections of liquidity into the system in question. Yet no-one knows what will happen when those policies are reversed, as the USA is the first country to do so. Looking beyond the decision to increase the cost of money, the inevitable question is when the Fed intends to shrink its balance sheet, which, lest we forget, has now topped the $4.5 trillion mark, compared with $800 million before the crisis. How such a move will affect the confidence of financial operators is uncertain. Central bankers will play it by ear, knowing that at some point they will be obliged to sell the assets built up over eight years.

The final unknown concerns the behaviour of financial assets, and stocks in particular. Many fear that a rate hike will favour a US stock market correction, at a time when its valuation is far from cheap. A fair amount of research on this issue shows that a rate increase poses no obstacle to a rise in the markets, or at least in the initial phase of the Fed’s monetary policy shift; actually, it is in the half year before a Fed move that shares tend to be vulnerable. The lacklustre performance of US securities in 2015 is perhaps still further confirmation of this unprecedented stock market reaction to a shift in monetary policy direction. In theory, the rate rise we foresee is not a reason to fear a bear market, especially since rates should return to normal levels at a gradual pace. In short, rather than its potential impact on stock prices, the big unknown with the US monetary policy shift is that no-one has ever had to handle that change within a global environment of unconventional policies.

Managing exits from unconventional monetary policies has always been a risk, and one that we have consistently highlighted. US policymakers have no doubt thought long and hard about how to proceed, but the possibility of mistakes cannot be ruled out! That being the case, the normalization of US policy is a necessity, if only to gauge the reactions of financial operators.

A rate increase should not be a cause of unwarranted concern. The worst case scenario lies elsewhere, i.e. in the need for the Fed to make an additional quantitative adjustment – a move that would be called for if the US economy were to take another dip. With Japan and Europe having finally rolled out unconventional monetary policies that by and large have fuelled stock market performance, a US QE4 could be a terrible blow. By confirming that liquidity injections are unable to stimulate the economic machine on a lasting basis, and by highlighting the limits of monetary policy, a US QE4 would leave the world without a driver, given the decisive role acquired by central bankers in the last few years.

Put briefly, a US rate hike in September 2015 is a source of uncertainties but not a reason to fear major negative consequences for the stock markets. We far prefer this perspective to that of a further quantitative adjustment in the USA, which would be the worst possible admission of powerlessness.

François Savary – Chief Strategist – Reyl & Cie