December 18, 2015
The US Federal Reserve has lifted rates by 25 basis points after almost a decade of being near zero. Federal Reserve Chair Janet Yellen’s dovish statement highlighted the goal of gradually returning to normalisation, with the ASX and American stock markets rallying after the news. The rate hike is likely to cause volatility in the short term, despite it being well signalled and widely expected by the market.
The Federal Reserve rate is important globally, not just in the United States. Many emerging markets raise capital in US Dollars and issue debt in the American market. Increased rates mean that they will not be able to raise money as cheaply as in the past. There is also the risk that there will be some flight of capital flight in these markets with investors returning to the American market, which is far more stable and has less political risk, to seek returns.
Here in Australia, the AUD is now facing downward pressure from a number of fronts. Commodity prices have been trending down for most of the year, and worries about our biggest export partner’s (China) growth, has weighed on the Australian Dollar. The AUD has been quite resilient to these downward pressures in recent months, however the Fed’s rate hike is going to put further downward pressure on the AUD.
Australia’s interest rates are quiet high relative to other developed economies. Australia has a low level of political risk and our regulators are seen as effective at managing the market participants. This has made Australia quite appealing to risk averse investors who are seeking yield wherever they can find it, and this has supported the currency in recent months. However, as the Federal Reserve has now lifted rates (albeit a small amount), it has indicated that it is on a path to normalisation, and that more importantly it believes the American economy is strong enough to handle the rate increase. This has signalled to many investors that their global search for safe yields may lead them to the American market once again. As the interest rate differential between Australia and the United States decreases, more money will leave our country and be invested in the US. This trend will only continue if the Federal Reserve stays on its path to normalisation, and will be exacerbated if there is an Australian rate cut, which is possible given the uncertainty in the Australian economy.
What does this mean for your investments? The most obvious effect of this is that solid companies with significant earnings overseas (such as CSL, Resmed and Henderson Group), as well as non-commodity exporters, are set to do well. When the overseas earnings of these companies are converted into AUD, it will be a larger amount of Australian dollars. A weaker AUD also makes our exports cheaper in the international market. One should be wary however of companies which have issued debt denominated in US Dollars, as the AUD cost of servicing that debt will increase.