It’s the end of an era for US interest rates: what happens now?

published 17 December 2015

151216-janet-yellen — Janet Yellen: raised US interest rates for the first time in nearly ten years

We have lift-off!

I'll admit, I had serious doubts about whether the US Federal Reserve would go through with raising rates last night. But in the end, Janet Yellen didn't bottle it.

So. US interest rates have gone up for the first time in nearly ten years. Not by much, mind from near-0% to a tiny bit less near-0%.

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But it's a start. And more importantly, it's a change of direction.

So what comes next?

What the Fed did

It put US interest rates up.

The Federal Funds target range (their equivalent of the Bank of England rate) has gone up to 0.25%-0.5%, from the 0%-0.25% area. The move was also unanimous so everyone agreed it was time.

That's quite interesting. The Fed was meant' to hike in September. But the Chinese stockmarket crash put it off. Yet here we are, facing a burgeoning meltdown' in junk bonds which has many of the more intelligent people in the market seemingly quite worried and the Fed has decided to go ahead anyway.

Maybe it reckons the damage from junk bonds will be contained'. Or maybe it weighed things up and figured out that if it didn't raise rates, that would freak the market out even more.

On that point, it's worth understanding that monetary policy has already effectively been tightened. The end of quantitative easing (QE), amid the taper', was tightening. A higher dollar makes monetary policy tighter. Rising junk bond yields do too

As the Market Anthropology blog points out, "taken in sequence, financial conditions have tightened significantly since May 2013". So in a way, this rate hike is just dotting the i's and crossing the t's.

What would be the biggest surprise for 2016?

Here's the logical argument: the US economy has firmly embarked on a tightening cycle. Everywhere else including China is slowing down and still straggling economically.

It all points to a stronger US dollar. And that is a tough argument to refute.

But one thing I've learned is that logic isn't always a good guide to what happens in markets. Particularly when the logic seems unassailable.

If everyone believes in the strong dollar' story, then that makes it all the more vulnerable to disappointment. You don't need much to happen you don't need to see many surprises' for that story to change.

Put it this way: your risk is all to the downside, while your upside reward is shrinking by the day, as more and more people buy the story.

So it's always worth examining the sorts of things that might disrupt this grand narrative in the year ahead.

Right now, the main market worry is deflationary collapse and rising corporate blow-ups, focused on the commodity sector. That collapse has been triggered partly by the rising US dollar and the weakening Chinese economy.

So what if something changes?

What if China isn't as weak as everyone thinks? What if the Fed isn't as keen on raising rates as everyone thinks right now? Or if it starts to fall behind the curve'?

What if commodity prices start to bottom out, and wages quickly start to pick up, and the US dollar bull market stutters? What if inflation becomes apparent as a result?

How will a market that has become accustomed to fretting over deflation react to that?

It's a scenario. I'm not saying it's what's going to happen no one knows. But, while it's a minority view, it's certainly not out of the question. And I don't think it's anywhere near priced in.

So that's what I'll be watching out for during 2016. And as far as your asset allocation goes, it still leaves me thinking that the riskiest asset class of all right now is bonds.

We'll have more on this in the Christmas edition of MoneyWeek magazine, out on Christmas Eve. Meanwhile, in this week's issue (out tomorrow) my colleague Alex Williams has picked out some of the key mining plays that should eventually be best-placed to benefit as the latest cycle grinds on.

If you're not a subscriber, bag yourself an early Christmas pressie, and subscribe now.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.