To Hike Or Not To Hike-Is That Really The Question To Ask?

A week before the Federal Reserve’s most critical policy decision in years, Wall Street opinion makers can’t agree on anything. Not only is there no consensus about whether the Fed will end its seven-year-old policy of zero interest rates, but views on the fallout from such a move are wildly disparate.  We’ll all find out more on Wednesday, when the FOMC issues its statement. As divided as the market is on that decision, it’s the aftermath that stirs the real split. Many say the economy is too weak for a rate hike, and fear the markets could tank. Others say the rate hike is warranted, even necessary, and would signal the economy is strong.

The real question is what will happen when interest rates rise? First up, a rate hike would strengthen the dollar, particularly if the hike is part of a long-term cycle. A stronger dollar would likely result in money flowing into the US. A stronger dollar means assets priced in dollars would go down in price; so we might anticipate weakness in commodities such as oil, industrial metals, and precious metals – pretty much all commodities except agriculture. In this way, a rate rise would be deflationary.

A stronger dollar would put even more pressure on emerging market currencies, which have already experienced pressure; there is still plenty of dollar denominated debt in emerging markets. Countries with current account deficits could expect to feel the pressure, led probably by Brazil.

For real estate, there is no question that lower interest rates spurred real estate purchasing activity. So, it stands to reason that an increase in rates will have the opposite effect, by reducing demand due to higher costs of money. Some say that a slight rise will cause a short-term increased demand for purchasing real estate; people think that rates will continue to rise, potentially keeping them out of the market in the future, and so they act. The longer-term effect is to tap the brakes on real estate.

For stocks on Wall Street, the impact of higher rates is tougher to call. Historically, there is no direct correlation between the start of a rate-rising cycle and a drop in stock prices. The reasoning is that rates are hiked when the economy is strong and the economy is humming along, perhaps humming along a bit too fast. Historically, Wall Street reacts negatively to surprise moves by the Fed (think 1987) but the Fed has been warning they will hike rates and they will do so slowly and incrementally – no surprises, just some guessing about the exact date. Most investors aren’t confident that the economy is strong right now; earnings growth has been flat, stocks have suffered a correction, and there is still slack in the labor market.

Ultimately, the stock market will respond to the fixed income and credit markets, and this is pretty straightforward; 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 and the biggest price drops will come for the assets with the greatest duration. The twist here is that long duration assets are widely perceived as less risky, because they carry a lower risk of default; for example: corporate bonds, or municipal bonds. Junk bonds carry greater credit risk, and are considered less sensitive to a rise in interest rates.

The biggest risk is that markets get panicked. People who think they have a low risk asset suddenly realize they are exposed, and they hit the sell button, which can lead to a herd or mob mentality. If prices go too far south too fast, credit markets can freeze, and when that happens, everything freezes. The gears grind to a halt and the markets crash. There really is no reason to expect a crash. The economy can withstand a little quarter point rate increase. We don’t know what the Fed will announce on Wednesday, but we should not be surprised by a hike.