What will happen if Fed hikes the rates?


17 September, AtoZForex.com, Vilnius – A general perception of economic consequences following a rate hike is bull stumbling, causing bond yields to rise and slipping the economy into a recession. However, how fast could it occur?

Stocks

Based on historical trends impact on equities market tends to get more pronounce later in the rate hike cycle.

“It does seem there is a trend for equity returns to stall 12-24 months after the first hike, which again perhaps reflects the lag in monetary policy,” Deutsche Bank analysts concluded from a recent study.

More specifically, according to an analysis of Bob Doll, chief equity strategist at Nuveen Asset Management, looking back over the past 35 years, anticipation has driven the market into a rate hike by approximately 14% return. Yet, afterwards 8 months of stagnation fallowed, with gains averaging 2.6%. However, 17 months into the hike thing get back to normal averaging 14.4% return over the prior six cycles.

GDP

As the current GDP levels of 3.6% fluctuates near the lowest point ever for a lift-off, if the Fed hikes the rates against such fragile economic backdrop, it could drastically increase the risk of recession.

According to Deutsche Bank, out of 118 rate hikes since 1950 only two had nominal y/y GDP below 4.5%. Despite the Q2 2015 was at 3.6%, the third quarter is tracking at just 1.5%, according to the Atlanta Fed.

“In our study since 1950, all hiking cycles to date have been in a super cycle of increasing leverage with GDP eclipsing pre-recession peaks very quickly post the recovery commencing,” the report noted. “By contrast this has been a uniquely slow recovery from what was the worst recession in the sample period.”

The Fed had been waiting by far the longest since the end of the last recession. The record had been 35 months, it is now 74 months and still counting.

Bonds

It would appear that bonds tend to react to the change of policy direction fester than the stocks do. “It does seem yields change direction immediately as the first hike/cut in the cycle arrives. At the end of the hiking cycle bond yields fall immediately,” Deutsche bank said.

Charles Schwab strategists think the hike will cause a yield gap between longer and shorter dated bonds to narrow, flattening the curve. High yield bonds tent to perform better in such backdrop, though “we are still cautious about stretching for yield,” Schwab pointed.

Who wins?

History reveals that ‘quality’ stocks often outperform during following three months after a hike, according to Goldman Sachs analysts.

“Firms with strong balance sheets outpaced weak balance sheet companies following each of the 1994, 1999, and 2004 rate hikes, by an average of 5 percentage points. Companies with high returns on capital as well as low volatility stocks also outperformed their lower quality counterparts, by an average of 4 (p.p.) and 3 (p.p.) respectively,” the report stated.

However, debt will become a big issue for entities. Companies with a high percentage of floating rate debt appear to lose the most, Goldman added. High dept multinationals might face rising dollar in a long run, making their products more costly in the global market and their debt more expensive to finance.

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