After bombarding the public with hints over the past several weeks, the US Federal Reserve (Fed) raised its key overnight Funds Rate 25 basis points at its meeting on Thursday. In her statement accompanying the decision, Fed Chair Janet Yellen, said risks to the economy were “roughly balanced” and inflation was moving close to its 2% target.However, she also pointed out that the inflation goal is symmetric, meaning it can go over the target for a while, just as it was under for a period. This implies that she isn’t in an urgent rush to raise interest rates again.
Reaction to the hike
Due to the Fed’s foreshadowing, money markets were not surprised by the move. They were surprised, however, by Fed Board members expecting only two further rises in the Funds Rate this year, which is roughly the same prediction as the last meeting in February. Many investors were a little nervous that Fed members would be more gung-ho about further interest rate increases, given the rosy economic news lately and calmness in markets. Therefore, there was some relief in markets immediately after the decision was announced, reflected by a fall in longer-term interest rates and a bounce in shares.
For investors, the Fed’s “steady-as-you-go” approach to interest rate hikes shouldn’t be too much of a headwind for shares and bonds, if economic growth continues to trundle along at a reasonable pace and inflation doesn’t get out of hand. In our view, there is a reasonable chance of both outcomes occurring, given the current healthy trends in new jobs, manufacturing activity, and consumer spending.
Impact on New Zealand
The Fed’s path of higher interest rates contrasts with the Reserve Bank of New Zealand’s signal that it is unlikely to move the Official Cash Rate (OCR) in the foreseeable future. Because of the respective directions of the US and New Zealand interest rates, the difference between interest rates in the two countries should narrow. This may make New Zealand a slightly less attractive destination for overseas investors seeking superior yields here on relatively safe securities, such as government bonds, highly-rated corporate bonds, and high dividend paying shares.
Easy money from the Fed has been a key reason for the New Zealand dollar strength against the US dollar in recent years, so a reduction in the attractiveness of New Zealand yields relative to the US could take pressure off our currency. New Zealand’s economy is still performing well, but looks like it could be starting to cool a little. This will also reduce the support for the Kiwi currency. For New Zealand investors with unhedged holdings in US shares, a weaker New Zealand dollar would provide an extra boost to returns in domestic currency terms.
However, nothing is certain in the world of investments and there are risks to the trends we’re currently seeing ahead. Chief among risks is the possibility that inflation in the US may rise faster and sooner than currently anticipated, which would require an even more forceful interest rate response from the Fed. In this case, shares and bonds may have a more difficult time. This is something we’re keeping a particularly close watch for.
This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.
John Carran, Senior Economist at Gareth Morgan Investments
You can read more articles by John on the GMI blog.