Implications Of A Fed Funds Rate Hike On Asian Securities – Matthews Asia

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Apr 17, 2015

All else equal, a higher U.S. federal funds rate makes both bonds and equities look less attractive, but all else is rarely equal.

The fear of a rate hike is powered by the tacit assumption that rates along the entire yield curve will rise in tandem. Only such a parallel upward shift would raise discount rates on all cash flows from risky assets (e.g., equities and corporate bonds). Consequently, the present value of those assets would decline, if cash flows stay the same.

Importantly, the Federal Reserve holds sway over only short-term rates through its setting of the federal funds rate. This policy rate may be affected more by Federal Open Market Committee assessments of economic growth than by inflation.

Moreover, this short rate is a weak lever on longer rates. Rates at longer maturities embed the compounded effect of expected future real rates, expected inflation and a term risk premium that captures the volatility of these factors. Market anticipation of higher future inflation, or the possibility of inflation surprises, will be expressed as higher long-term interest rates. The Fed’s credibility anchors these market expectations, and the loss of that credibility is perhaps the biggest risk to long-term rates.

In rate hike cycles over the past 20 years, Fed credibility may have been enhanced by the very act of raising rates in the first place. One indication is in the flattening of the U.S. yield curve. In each cycle, short rates rose more than long rates. Interestingly, in two of the past four hike cycles, the longer part of the curve (10-year to 30-year) declined in yield.

A parallel shift in the yield curve is as rare as receiving the equity market’s long-term average annual return in any single year. Most likely, a future federal funds rate hike will not translate into higher rates all along the curve.

As seen in Figure 1, only the 1994 rate hike cycle saw an upward shift in the entire yield curve, yet yields at longer maturities rose less than those at the front end.

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This small sample of rate hike cycles indicates that, at the very least, it is possible for long-term rates to decline following a rate hike. Once the Fed takes the first step to dampen inflation, expected inflation all along the yield curve declines. This effect can cause nominal yields to decline at longer maturities when the compounded effects of lower expected inflation overtake higher expected short rates.

What happened after the previous rate hike cycle?

Do risky assets sell off following a federal funds rate hike? To ground the discussion, let’s look at Asian sovereign bond returns (in USD terms) during the last federal funds rate hike cycle. In June 2004, the Fed embarked on the first of 17 rate hikes, staged in increments of 25 basis points (0.25%). By the time the cycle reversed into a rate cut cycle in August 2007, Asian bonds had generated a return of 27.8% (8.1% annualized).1

Figure 2 shows the steady march forward of Asian bonds through the last hike cycle.

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Asian equities also rallied (33.2% annualized for the MSCI AC Asia ex Japan Index) as did the S&P 500 Index (10.4% annualized). Even intermediate U.S. Treasurys generated a 3.7% annualized return over that period.2

And currencies?

The standard narrative is that a U.S. rate hike draws investors to the U.S. because of higher rates on dollar deposits. Alternatively, maybe a rate hike ratifies a view that the economy is on the path to sustained growth, boding well for U.S. equities. Then, the liquid and open U.S. capital markets absorb international investments, increasing demand for the dollar, and hurting Asian currencies.

Let’s look at the historical record in Figure 3. The June 1994 experience shows relatively stable Asian currencies leading up to the hike and strengthening in aggregate after the start of the hike.

From the start of the 1994 hike cycle until the beginning of the tightening cycle, Asian currencies gained 3.7% on average. Asian currencies were not hurt either in the 2004–2006 hiking cycle, when they gained 12.4% on average.

Higher returns on Asian bonds (vs. lower yielding U.S. Treasurys) were enhanced, not negated, by currency movements. Asian local bond total return outperformance (coupon + price return + currency appreciation) occurred during a 425 basis point (4.25%) rise in U.S. federal funds over the 2004–2006 cycle.

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