Stocks fall on the first official day when higher interest rates go into effect. The S&P500 fell 1.5% to 2,041 while the Dow Jones lost 1.4% to 17,495. Today’s movements put the S&P500 into negative territory for the year and the losses come after three consecutive days of gains. The Fed funds rate is now in the 25-50 basis point range and it has been communicated that subsequent hikes will be “gradual.” This initial interest rate increase is being dubbed by analysts and economists as a “dovish hike” or tighter monetary actions but accompanied by accommodative language from the Fed. In spite of this consensus the Fed expects the Fed funds rate to be 1% by the end of 2016 which is higher than what was expected in the market, which may be contributing to the unease in markets today. Energy stocks were the largest drag in indices as brent fell to $37.06 and WTI fell to $34.85. The dollar index rose 1.4% to 99.22 and the euro fell to $1.0812. The two year yield fell 1 basis point to 1% and the ten year yield lost 5 basis points to 2.24% while the 30 year lost 7 basis points. These movements represent a flatting yield curve as interest rates across the curve fall which is counterintuitive in light of the Fed’s action.
The Fed’s decision yesterday was met by reactionary monetary policy actions by central banks around the world. Different central banks reacted differently based on their own priorities and policy objectives. Higher rates in the US in general will lead to a stronger US dollar relative to foreign currencies which poses certain problems. Higher rates and a stronger dollar may lead to capital outflows from foreign countries, and higher borrowing costs for companies and countries who borrowed in US dollars. Saudi Arabia, Kuwait, UAE, Bahrain, Hong Kong, and Mexico all were among countries who raised interest rates. A representative from the ECB said that no immediate action will be required from the central bank. Norway, Indonesia, Philippines all kept rates constant saying that it was too early to assess the impact that higher US interest rates will have. Vietnam cut interest rates on dollar deposits in the country in order to disincentivize holding dollars. China, the UK, and the ECB are all going in opposite directions from the Fed.
In spite of the Fed’s tightening emerging markets still face the same set of challenges as before. Taiwan cut interest rates to possibly boost demand for its exports. China still remains a large uncertainty and many emerging markets are very dependent on the state of China’s economy. As it relates to China and the renminbi, capital outflows are expected to continue out of China as rates rise in the US. Countries such as China, South Korea, Indonesia, and India are all expected to cut interest rates in the future. Brazil is facing a different set of problems with inflation above 10% and as a result the central bank continues to raise rates. The modest growth in the US is unlikely to have a large effect and pull emerging markets out of their current state. Currencies in fixed income in Brazil, South Africa, and Turkey didn’t move materially following yesterday’s developments which suggests that the Fed’s move may have been priced in.
Brazil experiences its second credit rating downgrade. The first came from S&P in September, and now Fitch has cut the country’s credit to BB+ which is the highest possible junk rating. Moody’s is the last major rating agency not to regard the country’s debt as junk. Fitch cited the budget deficit, inflation, political risk, and trends in the commodity market as the main factors in its decision. The agency also left open the possibility for further cuts. The real fell 0.3% against the dollar and the yield on dollar denominated 10 year debt rose from 6.7% to nearly 7%. Analysts are looking for countries with high budget deficits and therefore a need to tap the international capital markets frequently. These countries will be most vulnerable in the current environment. Turkey, Brazil, and South Africa all meet that description. Barclays estimates that $1.6bn in Brazilian bonds will be sold as a result of the investment grade to junk rating change from funds that must hold only investment grade bonds per mandate. Low trading volumes in these markets could exacerbate price swings. Total return on Brazil bonds this year is -8.8%.