Fund managers ponder the potential impact of a U.S. rate hike

Michael McHugh, vice-president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond.

Steve Locke, senior vice-president and head of the fixed-income team at Mackenzie Investments. Locke and his team manage a wide range of mandates including Mackenzie Canadian Bond and Mackenzie Strategic Bond.

David Stonehouse, vice-president and member of the fixed-income team at AGF Investments Inc. He is responsible for a wide range of income-generating mandates including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond.

Morningstar columnist Sonita Horvitch moderated the discussion. Her three-part series continues on Wednesday and concludes on Friday.

Q: When will the U.S. Federal Reserve Board raise its policy interest rate? The target rate has been between 0% and 0.25%, since the end of 2008.

McHugh: Global factors have recently become more prominent in shaping the Fed’s decision. The weakness in the global equity market seems to be originating from the emerging markets, Asia and, more specifically, China. There are concerns about a broader slowdown in emerging markets and this has had a more significant impact on financial markets, recently. The Fed is sensitive to this and is seeking to contain the volatility in the U.S. financial markets. There’s uncertainty as to the long-term ramifications should the weakness in the global financial markets continue. How will this impact the U.S. dollar and potentially the domestic U.S. economy? The uncertainty, volatility and instability are likely to cause the Fed to pause and delay raising rates.

Stonehouse: The core twin objectives of the Fed are maximizing employment and keeping inflation contained in a target of around 2%. It has become mindful of a third prong of monetary policy, and that’s financial stability. The Fed has been clear about wanting to focus on the U.S. domestic economy in terms of making appropriate policy rate moves. Against this, the Fed has also indicated that it’s concerned about financial stability. It’s impossible for the Fed to ignore the impact of a move on the rest of the world.

The recent turmoil in the emerging markets and the capital markets, and consequently in the domestic U.S. financial markets, has likely influenced the Fed’s thinking as to whether or not to start hiking its policy rate in September.

McHugh: Domestic conditions would tend to support the Fed hiking rates this year, but global conditions could cause it to delay this.

Stonehouse: The U.S. economic numbers have been anemic enough that the Fed might, based on these alone, not want to increase its rate, that is, if you ignore where its monetary policy is at present. The U.S. economic growth rate is subdued, retail sales and industrial production have been underwhelming and U.S. inflation is low. This might suggest that there is no need for the Fed to move. The case for a rate hike is that the Fed policy rate is at zero and there’s no justification for this anymore. This was part of an emergency policy for the global financial crisis.

Q: What will be the timing of this rate hike?

Stonehouse: We at AGF have been expecting that the Fed would not raise rates until 2016. That’s been our expectation since 2014. I think that Michael is right that the odds are good that the Fed could delay raising its rate. But the Fed risks losing its credibility; at some point it’s going to have to make its move to a more normal federal funds rate.

McHugh: It’s an open question whether the Fed moves this December or it could push it out to 2016. A window to raise rates might have been lost. Low yields create a misallocation of capital and a distortion of asset pricing.

Locke: I think the Fed will move in December. The instability in financial markets is causing it to delay what would otherwise have been a 25-basis-point hike in September, with a slow trajectory of raising rates over the next one to two years. The Fed should raise rates. This is mainly to do with asset pricing and asset bubbles and debt creation globally. The Fed and other central banks have spurred this through low policy-rate environments combined with quantitative easing. The financial asset bubble becomes more tenuous over time, unless we prick it a little to release some of the air.

McHugh: Other factors are pricking the bubble already.

Locke: The risks that have already been created through low-yield environments, through low policy rates, have led us to this point of volatility in the market.

McHugh: Yes. It has inflated asset prices.

Locke: It’s caused moments of panic in certain markets, emerging markets in particular, over the past few months.

Stonehouse: In summary, given the macroeconomic backdrop, with the high debt levels, the challenges to stimulating economic growth through monetary policy, and the disinflationary if not deflationary pressures, we remain in a prolonged low-interest-rate environment. We’re looking at a gradual rate-hike cycle. Normally, with a rate hike, you would get a selloff in all aspects of the bond market. It might not necessarily play out that way this time.

McHugh: The policy rate at which the Fed is likely to pause or stop raising rates is likely to be lower than the historical levels reached at the end of a rate-hike cycle. The Fed’s objective in this cycle is to obtain a positive real federal funds rate. How will investors react to the initial hike? Historically, this has caused investors to sell bonds. This is a high probability. But this is likely to be tempered by the realization that it’s a more moderate path.

Locke: I agree. Once this round of Fed hikes begins, an abbreviated selloff in the bond market should be expected.

McHugh: There is an important wild card in the outlook, if foreign-exchange- reserve managers, particularly those in emerging-market Asia, sell U.S. Treasuries to support their currencies or to fund fiscal programs. China is a major holder of U.S. Treasuries. This move could put sizeable selling pressure on U.S. Treasuries, pushing those yields up. This could tighten financial conditions in the United States by increasing yields and risk premiums. This could challenge the Fed’s intent to tighten. The question is: Could this emerging-market central-bank selling cause U.S. bond yields to spike higher? The concern is that this selloff will not be measured and this will cause collateral damage. If it reflects concerns about weakening U.S. economic growth, it will likely coincide with equities selling off and adversely impact investor sentiment. It could potentially adversely impact business sentiment and business investment decisions. There are a lot of negative ramifications of such a sudden and sizeable selloff in U.S. Treasuries.

Q: What about the Bank of Canada and the Canadian bond market? Canada is on the opposite trajectory to the United States. (The Bank of Canada kept its policy rate at 0.50% on Sept. 9.)

Locke: Our expectation is that the Bank of Canada will cut its policy rate again. There was first a surprise cut to the rate in January (by 25 basis points to 0.75%), and the market expected a follow-up second cut in March or April. This was delayed until July, when there was a further cut of 25 basis points to 0.50%. The Canadian economy has clearly underperformed the Bank of Canada’s projections year-to-date. Looking at the last two quarters, Canada is in a technical recession. There is a meaningful erosion of some statistics, particularly around the regions affected by commodity prices, like Alberta and Saskatchewan. Given the economic data and the level of oil prices, we expect that the Bank of Canada will cut again.

McHugh: I believe another cut would be a mistake. Yields are already extremely low in Canada. It must be remembered that the commodity weakness is predominantly regional, not national. As it’s commodity-related, lower interest rates will not fix that problem. More significantly, financial leverage of Canadian households is high and continues to increase. Lowering the bank rate risks fuelling that financial leverage, creating the potential for a much bigger problem down the road.

Stonehouse: I concur with Michael.

Q: Will the outcome of the October federal election have an impact on the Canadian bond market?

McHugh: The risk is that if there is a left-leaning federal government, with the perception of a tax-and-spend policy stance going forward, this may cause foreign investors to divest their holdings of Canadian fixed-income securities. Given the expensive valuations of Canadian fixed-income securities relative to those in the United States, there is a lack of a cushion to buffer any tendency of foreign investors to divest Canadian fixed-income securities.

Part one of a three-part fixed-income roundtable.