How assets will react to a rate rise
Credit markets may pose highest risk, with investors ill-prepared
At present, the market judges the chance of such a move as only about one in four, and this sounds accurate to me. A rate rise now seems unlikely, but it is far from out of the question. So, here is a Long View guide to what will happen to different assets when rates rise.
With equities in the US, the picture is far more complex. The move has been so widely telegraphed that investors should have prepared for it. Historically, there is no direct correlation between the start of a rate-rising cycle and falls in equities. Such moves normally come when the economy is humming along well. When animal spirits are high, a rate rise can even be seen as a declaration of faith in the economy from the Fed.
But earnings growth has flattened out this year, stocks have already suffered a correction, and a rate rise would not be taken that way. People are nervous.
Ultimately, equities’ reaction will depend on what happens to the fixed income and credit markets. Here, the effect is less open to conjecture. Higher target rates set by the Fed will send bond yields higher, which means bond prices must go down.
With yields already low, the proportionate falls in prices need to be that much greater. Further, the greatest falls will come for the assets with the greatest duration — the technical term for measuring bond price sensitivity to changes in interest rates.
Worryingly, the long-duration assets that would be worst affected tend to be widely perceived as less risky, because they carry a lower risk of default — for example, high quality corporate bonds, or municipal bonds. (High-yield or ”junk” bonds, which carry greater credit risk, should be less sensitive to a rise in interest rates.)
Generally, risks are greatest when they are not perceived. People who have bought a security believing it to be high-risk tend to guard themselves against that risk; those who think they have a low-risk investment do not.
This could therefore amplify the risk of a full-blown financial “accident”. Unexpected and unhedged losses can lead to knock-on effects.
There are countervailing forces. Rate rises would attract capital into the “haven” of Treasury bonds, and this would alleviate the pressure (and support the stock market)
But the credit market is lumpier than the stock market. Rather than trading on an exchange, those who want to buy or sell bonds do so through a dealer, generally at a bank.
Since the financial crisis, banks have cut back drastically on the capital they allow their dealers to spend holding bonds or credit instruments. This has been done in large part under regulatory pressure, and it means there is far less money available for buying bonds.
Meanwhile, the amount of bonds in issue has increased in the years after the crisis, as part of the financial engineering encouraged by low interest rates. Companies have issued debt and used it to buy back stock.
That raises the spectre of many eager sellers failing to find a willing buyer, and watching as prices plummet. Again, there have been dress rehearsals for an incident like this, both in the past few weeks, and during the bond market “flash crash” last October.
Credit markets drive financial crises. If they freeze, then stocks will come thudding down — as happened during the crisis of 2008. That is the imponderable “nightmare scenario” that faces markets. Just how badly would the credit market react to a rate rise? It can only be answered once rates rise.
And that is why many in markets do not want to find out just yet — and why the bet is on that the Fed will decide not to find out either.
Now, all that remains is to wait a few more days and find out what the Fed decides. And those of us who are not central bankers should probably offer up prayers of thanks that we do not have to make the decisión.