As 2016 draws to a close, investors leave behind a year in which events repeatedly defied mainstream consensus. Improbabilities such as Brexit, a Trump presidency and a rejuvenated OPEC are now a part of entrenched reality. What is heartening is the ability of financial markets to swiftly re-price valuations to take into account the new realities. In this sense, these anti-consensus events have succeeded in jolting financial markets out of their “secular stagnation” stupor.
While the Fed’s December 2016 rate hike was widely expected, the committee’s forecasts implying three rate hikes in 2017 veered to the hawkish side. A fiscal stimulus under the incoming Trump administration will only accentuate it further. Sectors that are most likely to benefit from the Fed hiking cycle include US banking and insurance.
As fixed return instruments lose attractiveness with rising inflation, bonds yields will have to rise in order to compensate for the loss in their value. This will ease pressure on several bond markets, especially in Europe, suffering from negative yields.
Low inflation tempered the Fed’s hawkish bias in 2016
Apprehensions of a global slowdown were high in early 2016 due to global market volatility following Japan’s unexpected adoption of negative interest rates (January) and especially Brexit (June). The uncertainty following these events arguably tempered the Fed’s hawkish bias for the rest of year. The Fed actually ended up hiking rates only once in 2016 compared with the four times that was implied in its December 2015 forecasts.
The oil supply glut in early 2016 worsened fears that falling oil prices (which dipped below $30 per barrel in Q1-2016) would feed into global consumer prices and reinforce the deflation-stagnation loop. The prospect of higher oil prices was remote with OPEC’s inability to agree on production cuts for eight years. Oil analysts had already written the obituaries of the cartel. However, not only did OPEC reach a consensus amongst her factitious members, it also managed to persuade non-OPEC members like Russia to participate in the production cuts. Ever since we wrote about in our previous post, (See OPEC Regains its mojo, for now) Saudi Arabia has said that it will top up its original production cuts.
A higher oil price has materially changed the inflation outlook for 2017 and is arguably one of the key reasons for the Fed’s hawkish tilt. Additionally, a fiscal stimulus under the incoming Trump administration will only make it more hawkish. Former Fed chairman Alan Greenspan has acknowledged that markets are finally out of the “secular stagnation” mindset.
Sectors that are most likely to benefit from the Fed hiking cycle include banking and insurance. Higher rates would improve bank profitability by increasing the net interest income or the margin between the deposit and lending rates. In this regard, the clear winners would be banks with a US-centric loan book and higher proportion of loans to deposits.
Insurance companies are also key beneficiaries of rising interest rates as their bond investments start yielding higher returns. Life and health (L&H) insurers will benefit immediately as they have a greater share of their investments allocated to bond investments compared to property and casualty (P&C) insurers that tend to diversify into equities, real estate and cash. According to the 2015 annual report of the US Federal Insurance Office, L&H insurers held 74% of their total assets in bonds while the figure was 62% for P&C insurers.
Bond yields will rise in 2017
On the other side of the Atlantic, the European Central Bank’s decision to trim its monthly bond purchases to EUR60 billion from EUR80 billion starting April 2017 has had the announcement effect of a monetary tightening. The fact that the ECB’s trim will occur alongside monetary tightening in the US has implications for developed market bond yields. As fixed return instruments lose attractiveness with rising inflation, bonds yields will have to rise in order to compensate for the loss in their value. This rise bond yields in 2017 will ease pressure on several bond markets, especially in Europe, suffering from negative yields.
For the first time since the 2008 financial crisis, financial markets finally appear ready to get over their addiction to bonds.
Janki Sharma is a freelance economist based in Singapore and writes for Macrovue.
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