US raises interest rates – implications

The US Federal Reserve (Fed) has raised interest rates by 25 basis points, to a new target range of 0.75–1%. The rate increase was widely anticipated, but the Fed statement and projections reassured investors that the central bank is not becoming significantly more hawkish. Ten-year Treasury bond prices rallied, US equities rose an additional 0.5%, and the euro climbed 0.8% against the US dollar to 1.07. We believe that a gradual normalization of US monetary policy signals Fed confidence in the health of the economy, and should therefore support risk assets.

This is just the third US rate hike since the 2008 financial crisis, but the median Fed policymaker expects two more rate hikes this year, and three in both 2018 and 2019, broadly in line with our expectations. Higher rates are well supported by positive economic projections. The Fed boosted its forecast for US economic growth next year (to 2.1% from 2% in December), while marking up predictions for core inflation this year (to 1.9% following a 1.8% expectation previously).

The Fed maintained its median estimate of the “terminal rate” (or the expected peak level of interest rates in this cycle) at 3%. All told, the terminal rate is still set to be significantly lower than in previous rate hike cycles.

Here's our view on the impact on the key asset classes:

Equities. The Fed's hike comes alongside a resilient, synchronized improvement in US and global economic activity, which should more than offset the negative impact of higher short-term borrowing costs. We're overweight US and global equities relative to high-quality government and corporate bonds in global tactical asset allocations. As long as the Fed continues to move rates in line with economic developments, and doesn't seek to hike aggressively to curb inflation, we believe businesses can absorb higher debt costs and continue to grow profits.

Bonds. In the unlikely event that the Fed tightens policy more aggressively than anticipated by the market, short- and medium-dated government bonds would be more vulnerable to price setbacks than long-duration securities. We believe longer-maturity bond returns will be supported. Ten-year Treasuries appear to have priced in a full US rate cycle, and the 10-year yield even fell seven basis points after the Fed's dovish commentary. Longer-dated sovereign bonds also have a diversifying role in multi-asset portfolios, since they tend to gain if weaker growth undermines stocks. And the carry offered by 10-year Treasury bonds is higher than the returns available on cash. We are therefore overweight US government bonds with 10-year maturities relative to cash.

US dollar. We believe the current valuation of the dollar suggests that higher rates are well priced into the market. We find the US dollar overvalued versus most G10 currencies – for example, it trades at a 15% premium to our fair value estimation against the euro. And the USD could come under more pressure if President Trump's infrastructure spending plans meet resistance from fiscal conservatives in Congress.

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