UBS: Federal Reserve raises US rates

But we believe the commentary from the Fed remains broadly supportive for risky assets, and interpret the move as a “neutral hike” that reflects the improvement in the US economy. Inflation forecasts remain unchanged, Yellen reiterated that policy remains accommodative, and that the “neutral” level of the Fed funds rate is low.

We maintain our risk-on stance, with overweight positions in US equities and euro high yield credit. We keep our overweight position in the euro relative to the US dollar. Additionally we reiterate our overweight position in emerging market equities versus Swiss stocks.

What happened?

In line with market expectations, the Fed has raised interest rates by 0.25% to 0.5-0.75%. The Fed issued an upbeat economic assessment, with officials underlining that market-based inflation expectations had "moved up considerably" amid solid job growth and rising household spending. The Summary of Economic Projections showed that the median participant now expects three 25 basis point hikes in 2017, one more than previously forecast. The median expectation for 2017 real GDP growth edged up to 2.1% from 2.0% in September, while projections for unemployment at the end of 2017 fell to 4.5% from 4.6% previously. Inflation forecasts for 2017 and beyond were unchanged, with the core PCE inflation rate not expected to hit the Fed's 2% target until the end of 2018.

How did markets react?

The S&P 500 index, which was flat ahead of the Fed statement, fell 0.8%. The sell-off was comparatively mild given the 9% rally in US stocks since early November. The Bloomberg Dollar Spot index climbed 0.8% and the euro fell versus the dollar, briefly breaking below EURUSD 1.05 before regaining some ground. Two year US Treasury yields reached the highest level in seven years, rising 10 basis points to 1.26%. The US 10-year yield rose by 10 basis points to 2.57%.

What does this mean for… 

Equities

We remain overweight US and emerging market equities. Although equities have fallen modestly after the announcement, we do not expect a repeat of the larger sell-off that followed the Fed's last rate hike in December 2015. A year ago, US earnings growth was negative and decelerating, oil prices were falling, the manufacturing surveys pointed to contraction, and uncertainty was high over Chinese government policy. In contrast, at present year-on-year US earnings growth has turned positive, oil prices have been trending higher, the manufacturing sector is expanding, and risks of a Chinese hard landing appear lower.

Higher rates should also favor cyclical over defensive equity markets. We reiterate our overweight position in emerging market stocks versus our underweight position in Swiss equities given a high index weighting toward lower-volatility, bond-proxy sectors.

US dollar

We keep our negative view on the US dollar relative to the euro. Although the US dollar has strengthened modestly in the aftermath of the decision, Yellen assured investors that she continues to envisage only a gradual tightening of US monetary policy, and inflation projections remain modest. With the dollar still significantly overvalued relative to the euro, we see EURUSD moving higher over the next six months as Europe’s growth and inflation outlook improve.

Government bonds

We remain underweight high grade bonds in global portfolios. Moves so far in US government bond yields look consistent with the Fed's projections for slightly higher growth, lower unemployment, and inflation advancing toward the 2% price stability goal. That said, a sharp and persistent rise in yields looks unlikely given cautious tightening from the Fed, along with the Fed's reiteration of a 3% long-term Fed funds rate.

Conclusion

The initial market reaction seems to indicate some market participants found the statement slightly more hawkish than expected. This perhaps reflected the small move up in the “dot plot”, or Yellen's comment that fiscal stimulus was "not obviously needed" and that she was not advocating an experiment in a high-pressure economy. However, we maintain our view that a combination of improving US economic growth and gradually rising inflation provides a positive backdrop for risky assets into the new year. We affirm our global tactical asset allocation positioning.

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