The Effects of a U.S. Rate Hike on the Yield Curve

by Gerald Hwang of Matthews Asia

“The fear of a rate hike is powered by the tacit assumption that rates along the entire yield curve will rise in tandem. Only such a parallel upward shift would raise discount rates on all cash flows from risky assets (e.g. equities and corporate bonds). Consequently, the present value of those assets would decline, if cash flows stay the same. Importantly, the Federal Reserve holds sway over only short-term rates through its setting of the federal funds rate. This policy rate may be affected more by Federal Open Market Committee assessments of economic growth than by inflation.

Moreover, this short rate is a weak lever on longer rates. Rates at longer maturities embed the compounded effect of expected future real rates, expected inflation and a term risk premium that captures the volatility of these factors. Market anticipation of higher future inflation, or the possibility of inflation surprises, will be expressed as higher long-term interest rates. The Fed’s credibility anchors these market expectations, and the loss of that credibility is perhaps the biggest risk to long-term rates.

In rate hike cycles over the past 20 years, Fed credibility may have been enhanced by the very act of raising rates in the first place. One indication is in the flattening of the U.S. yield curve. In each cycle, short rates rose more than long rates. Interestingly, in two of the past four hike cycles, the longer part of the curve (10-year to 30-year) declined in yield. A parallel shift in the yield curve is as rare as receiving the equity market’s long-term average annual return in any single year. Most likely, a future federal funds rate hike will not translate into higher rates all along the curve.

As seen in Figure 1, only the 1994 rate hike cycle saw an upward shift in the entire yield curve, yet yields at longer maturities rose less than those at the front end.

 

Source: http://www.advisorperspectives.com/commentaries/20150416-matthews-asia-implications-of-a-fed-funds-rate-hike-on-asian-securities

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