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Countdown to the Fed meeting

  • Risk Manager
  • Blog post submitted on 11th December 2015

The last major central bank meeting of this year is inevitably coming in just a few days and it seems poised to find markets in derive. What is more, the Federal Reserve’s (Fed) meeting comes shortly after the ECB failed to rise to investors’ expectations and, most would say, to Draghi’s own subtle guidance. This has prompted many to take profits on equities and other risk assets.

What could Fed change? To start off, the consensus among analysts seems to be that Fed will (finally) increase its key rate by a small and rather symbolic 0.25 percentage points but, and this is probably more important, will emphasize that the outlook is weaker than in the previous cycles and that this will warrant a more gradual pace of tightening. Such a hike with a dovish tone (as many of the analysts have labelled it) is deemed to be a “ a sweet spot” for equities and high yield bonds as it means that the economy has stabilized enough to move past the zero rates policy era but not enough to prompt sizable interest rate risks.

Consequently, at this stage my guess is that failing to hike rates next week would be negative for US risk assets. It could also exacerbate the renewed weakness we have seen in commodities as a surprising deferral would send a bearish signal regarding growth. Consequently, the emerging market equities and bonds might fail to bottom even though the selloff was underpinned to some extent by worries of a debt crisis in the aftermath of the upcoming Fed rate hike. On a related note, the USD high yield market would likely continue to perform poorly given the large exposure to energy and basic material names.

Remaining in the USD high yield space, this month has brought about sizable losses following the dip in crude oil, iron ore and other commodities which took a toll on the US shale gas issuers and emerging market issuers. Whereas the US issuers more exposed to the domestic sectors should have been supported by the macro outlook, we have seen some contagion, presumably due to fears of ETF outflows and year-end profit taking. That is, given that ETFs replicate the composition of the indices and that the widely used USD High Yield Iboxx Index has a large exposure to energy names, the renewed pressure on this sector has triggered ETF redemptions; the latter in turn force the funds to sell the other names in the index. This forced-selling and the weak liquidity characteristic for the year-end have thus caused some contagion from the energy bonds to other bonds with stronger fundamentals.

As such technical risks gradually subside, they should be as well balanced by the attractive valuations as many of the US names have widened significantly relative to their European peers although the two economies have diverged in terms of growth. What is more, the European investors are now left wondering whether ECB made the right choice in delivering less monetary easing than it was expecting.

Overall, the last few weeks of this year are due to challenge investors in many ways as they have to assess the outlook of commodity markets, the vulnerability of emerging markets, the accuracy of ECB decisions/forecasts, liquidity risks, risks relating to forced-selling and geopolitical back swans. Ultimately however all of these will have to be judged relative to valuations (eg bonds yields/spreads or earnings multiples/dividend yields).

Have a nice day!

Raluca

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