The Fed moves – but what's next?

The U.S. Federal Reserve has raised its benchmark interest rate for the first time in almost a decade. The 25 basis point hike, a unanimous decision by members of the Federal Open Market Committee (FOMC), ends the longest US interest rate trough in modern history, with 84 months of near-zero official rates.

But while the decision marks a significant milestone in the U.S. recovery from the 2008 financial crisis, we believe the timing of the move is less important than the pace of subsequent rate rises. This initial tightening of a still expansionary U.S. monetary policy also comes at a time when counterparts like the European Central Bank are continuing to ease. We remain positive on the outlook for riskier assets, with the euro zone and Japanese equity markets offering the best potential returns.

Janet Yellen
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Janet Yellen

The Fed's move is warranted given the U.S. economy's substantial progress since 2009, particularly in the jobs market. The FOMC members noted that a "considerable improvement in labor market conditions" made them "reasonably confident" that inflation would climb towards the Fed's objective.

Fed Chair Janet Yellen reasserted that "the process of normalizing interest rates is likely to proceed gradually." The FOMC also reduced its forecast for core PCE inflation for 2016 to 1.6 percent from 1.7 percent in its September estimate. In their statement, FOMC members emphasized that the trajectory of rates would depend "on the economic outlook as informed by incoming data."

As a result, we expect both the U.S. and global economies to cope with this gentle rate hiking cycle. More relaxed monetary policy in the euro zone, Japan and China should also continue to support credit conditions. In addition, signs of economic stabilization in China and a broadening recovery in the euro zone will promote economic and corporate earnings growth.

Markets gave a relaxed response initially to the decision, but the S&P 500 climbed through the press conference, and had risen 1.3 percent by close of the trading session. The yield on 10-year Treasury bonds was essentially unchanged and the dollar was moderately higher against the currencies of major trading partners. Investors should be aware, however, that the immediate response to Fed decisions is not always a reliable indicator of where markets will settle.

Since U.S. rates are rising due to stronger domestic activity, we believe that the outlook for risk assets remains positive. We expect a continued positive trend in private consumption in the U.S. and other regions, driven by the ongoing recovery in labor markets and further supported by recent oil price declines. History shows U.S. equities have tended to rise in the 12 months after the first rate hike, with an average increase of 3.1 percent over the past three cycles since 1994. But on balance we believe the euro zone and Japan will outperform due to looser monetary policy, and continued earnings growth.

Over the same period emerging market equities have risen an average of 6.8 percent in the 12 months following the start of a Fed tightening cycle. We expect a less favorable outcome this time. Global oversupply in many raw materials, especially oil, will continue to put pressure on commodity-heavy emerging economies. We maintain a neutral stance on emerging market equities.

In fixed income, we expect 10-year Treasury yields to climb to 2.5 percent in 12 months, from 2.3 percent today. We remain underweight high grade debt, although strategic exposure to the asset class is warranted to smooth portfolio volatility, and provide some insurance against possible policy missteps.

We have seen credit spreads widening this year, notably in U.S. high yield bonds. Given that credit markets tend to perform well amid rising economic growth, U.S. high yield debt should deliver positive 12-month returns. We remain neutral on U.S. high yield bonds and continue to recommend an overweight in euro zone high yield bonds versus high grade bonds and short duration investment grade credit. This position is supported by our forecast default rate in euro zone high yield of below 2 percent for next year, compared with 5 percent for U.S. high yield.

A first Fed hike and gradual 2016 tightening cycle should not fuel a further leg-up in the U.S. dollar. In fact, we think that against major peers like the euro and yen, only a modest appreciation is likely over six months. We expect the euro-U.S. dollar exchange rate to trade close to 1.08 in six months, and the greenback to buy 127 yen.

Now that the first move is out of the way, market attention will turn to the speed of future Fed rate hikes. Aside from carefully monitoring the economic data and statements from the Fed, we will look for guidance from the evolution of the 'dot plot', which represents the rate outlook from Fed officials. This latest dot plot in December indicated about 100 basis points of tightening per annum in 2016 and 2017. The Fed funds rate for 2017 implied by the dot plot was more dovish, with a median forecast of 2.4 percent, from 2.6 percent in the September release and 2.9 percent in the June statement.

While we expect investors to take the Fed decision in their stride, we will be closely watching for signs of rising volatility and checking credit spreads for indications of an adverse market reaction.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $1.9 trillion in invested assets. Follow UBS on Twitter @UBS.