Cast your mind back to 2004: a fledgling social networking platform, Facebook, was launched; the television sitcom Friends completed a decade-long run; and the Federal Reserve embarked on what would eventually be a two-year tightening cycle of US interest rates.
It is now 11 years since the US central bank last began raising rates and, among finance professionals, memories of such an increase have grown ever fainter.
At least at the junior end, Wall Street is now peppered with traders and investors who possess no first-hand professional experience of an interest rate rise. Even for finance veterans, the habit of measuring one’s profit and loss on a day-to-day basis leads to notoriously goldfish-like memory spans and it has been six years since rates were last above the zero bound.
Despite investors and traders recently adjusting their forecasts for a rate rise to earlier this year their expectations of the size and shape of such a move remain distinctly out of whack with the Fed’s own projections.
The interest rate futures market, where investors bet on the future direction of US interest rates, is pricing in no more than 50 basis points of rate rises by the end of this year. By the end of 2017, futures traders are expecting a Fed funds rate of only 1.89 per cent. After that they are forecasting a rate of about 2 per cent.
All of those figures differ significantly from the Fed’s own projections, as illustrated in the central bank’s (in) famous “dot plot”. The median forecast in the latest set of the Fed’s distinctive spots from December shows the target rate reaching 1.38 per cent by the end of the year and then topping out at 3.75 per cent sometime in 2017.
While a rise of that magnitude may seem dramatic in the wake of six years of near-zero rates, in reality it is on a par with the size and shape of a typical tightening cycle.
According to Deutsche Bank data, while the average cumulative rate rise over the dozen US tightening cycles between 1954 and 2006 comes out to 531 bps, stripping out cycles that coincided with a period of very high inflation yields an average rate rise of 355 bps over a period of 26 months — very much in line with the Fed’s current forecast.
“We believe that when the Fed begins the process of rate normalisation around the middle of this year, the path of tightening will look very similar to the ‘average’ cycle,” Joseph LaVorgna and Brett Ryan, Deutsche Bank economists, wrote last week. “Financial markets are not prepared for such an outcome,” they added.
The difficulty is that while the Fed looks on course for an “average” tightening cycle financial market conditions remain anything but, which may be one reason why the expectations of futures traders differ so from the Fed’s own forecasts.
Years of ultra-low interest rates have become integrated into the very fabric of markets. Asset managers live and die by their interest rate bets. Hundreds of billions of dollars have poured into riskier asset classes as investors seek out higher returns with borrowed money, or leverage, used to amplify profits.
Companies and countries outside the US have borrowed $9tn of dollar-denominated debt that will become more difficult to pay as rates rise and the dollar strengthens, according to the Bank for International Settlements. Interest rates above zero have slid out of view for the risk models used by big banks and investors, many of which gauge market volatility over a five-year period.
This means that the sheer number of things the Fed will have to consider as it embarks on its first interest rate rise in many years is dizzying. On top of the usual elements like inflation and unemployment there is the reaction of financial markets, both domestic and international, as well as the unknown responses of traders and investors, some of whom will never have encountered a rate rise in their careers.
Investors betting that a Fed faced with so many tricky considerations will find itself reluctant to increase interest rates should feel comfortable taking on more risk. Those who think the central bank will ultimately embark on its projected “normal” rate rise during extraordinary times should proceed with caution.
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