Our 2016 market outlook for interest rates

The Federal Reserve raised U.S. interest rates for the first time in more than 10 years. This should help stocks outperform bonds. Most forecasters expect the U.S. central bank to raise rates again in the first quarter. But in our outlook for U.S. interest rates, we expect them to pause.

The Federal Reserve, or ‘Fed’, raised its federal funds rate for the first time in over 10 years. The American central bank’s benchmark rate is up by a quarter of a percentage point. It’s now up by 0.25 to 0.50 per cent. This will send up other interest rates in the U.S.

The Bank of Canada is unlikely to raise its interest rate anytime soon. In fact, if anything, the Canadian central bank is more likely to cut its benchmark overnight lending rate. Just keep in mind that the Bank of Canada controls only short-term rates. The further out the maturity date of a bond, the less influence the Bank of Canada has. As a result, as interest rates rise south of the border, the yields on longer-term Canadian bonds are likely to rise, too.

We expect stocks to now beat bonds

The market expected the Fed to raise U.S. interest rates. That’s partly why the stock market handled the actual increase well. In addition, the Fed’s decision shows that it sees the U.S. economy as being strong enough to manage to grow despite higher rates. A stronger economy raises company profits. In the long run, company profits set stock prices.

Higher interest rates will hurt the bond market outlook. Indeed, to match the yield on newly-issued bonds, existing bonds will have to sell for less. Prices will decline to the point where gains on the face value and interest payments yield as much as new bonds.

We’re at the stage where the performances of stocks and bonds diverge. Stocks usually beat bonds when interest rates are low, but also rising slowly. So put new money into stocks. Particularly if this year’s market setback has reduced how much money you have in stocks. But high-yield investments could come under pressure. One that comes to mind is REITs (Real Estate Investment Trusts).

When will the Fed increase interest rates further? About 62 per cent of Wall Street experts expect another increase in the first quarter of 2016. We disagree. Our view is that the Fed will not raise U.S. interest rates in the first quarter. Here’s why.

First, chair Janet Yellen emphasized that the Fed will only gradually raise interest rates. It makes sense for the Fed to first see the effects of the increase before going further. There’s a lag before changes in monetary policy take effect. This suggests the Fed should proceed slowly and cautiously.

Second, higher U.S. interest rates will attract a lot of hot money from around the world. This will likely raise the value of the dollar. An even higher dollar will make U.S. goods less competitive in international markets. A higher dollar will also reduce the value of sales and earnings in foreign currencies. So the Fed’s ‘liftoff’ of interest rates is likely to pause.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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