Last night, as expected, the US Federal Reserve Bank announced that interest rates will be increased by 0.25% and are now operating within a target range between 0.25% and 0.50%.

Below, our Chief Investment Officer, Colin Beveridge, explains the reasons behind the rise and what we can expect from the markets going forward.

Why is this happening now?

In recent months, the US economy has continued to recover and expand, and it was deemed capable of withstanding a modest degree of monetary tightening. It is important to note that the move was fully expected, leading to US shares rallying after the announcement was made.

When was the last rate rise?

The last rate increase was in 2006.

Was this expected by True Potential Investments and your fund partners?

Ahead of the Federal Reserve meeting, we discussed the likely outcome with each of our fund sub-managers and strategy fund managers. We all expected a rate rise. In fact, two managers pointed out that at least three further modest rises are anticipated and already priced into future expectations.

What concerns does True Potential Investments have about monetary tightening?

In general, we and our fund partners are relatively sanguine about tightening credit conditions in the US. We anticipate a worsening in credit defaults, but this is largely associated with particular sectors, such as energy and mining, where excess supply factors dominate driving down prices.

Aside from business cycle trends, we are mainly concerned about investor behavioural tendencies. The areas of the market at greatest risk from this are those where investors have bought illiquid investments. Should they decide to exit quickly, and simultaneously, the resulting outcome will be panic. Funds that are concentrated in US corporate high yield and poorer quality corporate credit are at most risk. To a small extent, this is happening already with a few funds in the US imposing exit penalties and one even barring redemptions. If this becomes widespread, it could cause contagion into Emerging Market Bonds.

How will this impact on future investment returns?

Removal of cheap finance conditions will likely move at a slow pace. The US Central Bank is aware of the dangers of raising rates too quickly. When it comes to raising rates here at home, we know that the Bank of England will lag behind the US.

There is little doubt that businesses with inefficient operating models, propped up by cheap money, will struggle even more and will eventually be flushed out. The majority of our fund partners believe that economic growth will be slowed. However, this should ensure an elongated cycle that supports equities while not unduly disturbing Fixed Income Markets.

With that said, there is a strong view that volatility will rise, which will make multi-asset investing more important than ever. The recent introduction of our Managed Portfolio Series discretionary solutions now appears to be well timed. We believe that different manager styles in each of the models adds a further layer of diversity that will prove beneficial to investors during what is a major adjustment phase back to ‘normal’ interest rates levels.

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