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Who's afraid of the Fed?

The US Federal Reserve will announce its interest rate decision at the conclusion of the FOMC meeting early on Thursday morning Australian time. The investment world is watching. A quarter percent lift in rates is the overwhelming consensus.  The almost certain rise means the focus turns to the “dot plot” – the board members’ estimates of where rates will sit in the future.

The previous estimate from the Fed board pointed to two more 0.25% increases in interest rates over 2017. That is, the cash rate will be 1.00-1.25% by December next year.  This is in keeping with comments from Chair Yellen and other voting members that the trajectory higher for interest rates is “gentle and gradual”. Obviously the Fed board is just as concerned about damaging a fragile economic recovery as the most pessimistic commentator.

Why does this matter to Australian investors? Let me count the ways.

Interest rates.  A rising interest rate environment in the US means Australian rates are more likely to increase. This is driven by direct and indirect effects. International investors are naturally attracted to higher returns. To stay competitive for investment, Australian rates may also have to rise. This is playing out in bond markets, where the yield on ten year bonds keeps hitting new multi-year highs. From lows at 1.81 % the rise hit 2.86% yesterday, and shows no signs of reversal.

Currency. One of the effects of a higher interest rate regime is that it attracts investors – and they must buy the local currency. Higher US rates will almost certainly mean a higher USD. Most of the effects that are relevant to the Australian economy are transmitted through changes in currencies.

The flip side for a rising USD is a falling AUD. A lower local currency makes Australian goods more attractive to US buyers, allowing the local economy to import demand, and with it inflationary pressures, from the US. While the immediate stimulus from this anticipated activity is currently most welcome, it may eventually lead to the Australian economy’s next big issue – inflation.

The impact on shares is less straightforward, as different aspects of an increasing interest rate environment push in opposite directions. Higher borrowing costs are bad news for business. Additionally, discounted cash-flow valuations (DCF) have a heavy reliance on interest rates. As rates rise from zero in many countries the impact on analysts share price valuations is negative and immediate.

Alert readers may point out that despite the lift in longer term US rates occurring in anticipation of this week’s decision, US share market indicators are hitting all-time highs. The cost and valuation impacts are still relevant, but US investors are possibly responding to the broader economic improvement that is driving rates higher.

The Fed needs a stronger economy to unwind the easy money conditions it created in response to the GFC. The fact it is prepared to continue the process now, after a 12 month pause, is a signal to investors that the US economy is in better shape. This signalling aspect of central bank action is well studied, and much analysis shows that in broad terms share markets rise for approximately the first two years of interest rate increases.

The big risk. So far, so positive.  An improving US economy and its rising share market are good news for Australian investors. However the rising USD may also bring the largest headache. As the USD rises those with managed currencies have allowed a depreciation of their local currency. The USD has risen from 6.0 yuan to closer to 7.0 yuan. This appreciation in USD/CNH makes goods from China more attractive to US buyers, and US goods less attractive to buyers in China.

And that’s the problem.

US domestic  politics, in seeming blind ignorance of the Fed’s $4 trillion dollar balance sheet, regularly kick around the “China is a currency manipulator” football. Forget the TPP trade deal, forget renewed US oil and gas production. US sabre-rattling over China may represent the biggest risk for Australian investors.

The almost inevitable coming increases in US rates are yet another strand for investors to weave into their world view. The conflicting currents the environment creates will likely add to overall volatility. This further reinforces the need for investors seeking superior returns to act when markets move.

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