Author: An Li Xu, Jia Qi Jiang

The US Federal Reserve announced its decision on short-term interest rate policies last Thursday September 17. Although they have issued multiple warnings and prepared the market for possible increases in interest rates this year, it remains uncertain when they will actually make the first move. The decision made on Thursday reflects doubts over the health of the global economy and financial market, as well as the Federal Reserve’s fears that after seven years of easy credit and low interest rates, the market and the economy will be unable to adjust to the change. So what might happen if the Federal Reserve does in fact increase the rates?

Commercial and Corporate Bonds:

It may have been a while since  rates have changed, but simple Bond math suggests that if the base rate increases, overall bond price falls. The impact varies between different grades and maturities of bond. With high graded corporate bonds having higher interests, the cushion is sufficient to absorb some price impact from rising base rates. The bad news is for high-yield, low graded bonds (BBB or lower) where their price is expected to fluctuate and decrease significantly relative to higher graded bonds. The maturity of the bond also matters, especially for newer issued bonds with a maturity of more than 5 years. According to my model, if the Federal Reserve increases the rates +0.25 every month consecutively for the next two years (as they did in the 2004 and 2005 rate hike cycle), a pseudo high yield bond of 10 year maturity issued at 2010 with an interest rate of 8% will loose nearly 40% of its value by 2017 when the primary rate reaches 6.75.  

Banks:

The possibility of raising the primary rate is good news for banks. Bank loans are anchored on the Federal Reserve’s target rate, and if the target rate increases, banks can charge higher for their loans. This will significantly increase the net interest margin, which is an important indicator of banks’ profitability.

Equities:

Similar to Bonds, the impact of rate increase on equities varies. Do expect a significant amount of cash flowing out of the equity market to gradually join the bond market. This would occur for high dividend stocks, namely utility and telecom companies for example. Although they were attractive in the low yield environment, their prospects may change in the coming changing credit environment.

No change is expected for growth stocks with healthy balance sheets: since investors are in for profit through stock price appreciation, the changing credit landscape will not affect them.

Thus overall, a rate hike will significantly change the current landscape for the credit and bond market. However since the Federal Reserve has been publically announcing the possibility of rate hike, the market should have digested this information and factored in the possible risk in prices already. But the ambiguity over how much of a raise it will be, for how long and how frequent still puzzles us.

See Figure 1 for rate hike cycle reference.

Should we expect a similar rate hike cycle to 1993, or 1999 or 2003? Or will this rate hike be completely different and more extreme than previous cycles? As per the renowned practician Nassim Nicolas Taleb, “always expect the worse, because things can always be worse.” The question is how much worse?

The economic and labor statistics have been improving since 2009, and the consistent real GDP growth of approximately 2% demonstrates the country’s ability to stop the stimulus plan. Then why hasn’t the rate increased yet?

My analysis suggests that the Federal Reserve is waiting for the right time to start a long cycle of rate hikes that may be longer than the one in 2003. The Fed has the choice to either increase its rates gradually, taking in feedback from the market and then adjust its rate accordingly, or start a hiking cycle. Apparently the first option did not happen, and the alternative is more than likely to occur in the near future. The problem is timing. The Fed does not want to surprise the market and disturb the current economic outlook, and as a consequence, it needs to prepare the market for rate hikes. Once the market shows signs that it is prepared, the cycle will begin.