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December Rate Hike – then what?

The December rate hike is now clearly going to happen.  The Fed has been spelling this out in its messages to the market.  Expectations are for a 0.25 to 0.5 hike.  In all likelihood it will be 0.25.

The big question is what happens next.  Since by all accounts the rate hike is now built into market expectations.  Recent polls of economists by the FT and Bloomberg show a vast majority (nearly 100%) now expect a rate hike.

Will there be 2, 3 or 4 more rate hikes in 2016 plus additional hikes in 2017?  My forecast is for 2 more hikes in 2016 with a lesser chance of 3 hikes.  I strongly doubt that there will be 4 hikes in 2016.  Unless of course the gradual really means gradual and the hikes are smaller individually.

Expectations about how these hikes will play out in 2016 and 2017 will have a key impact on the bond market, specifically high-yield and junk bonds, plus emerging markets.

In the bond market, corporate bonds especially energy-related ones face additional pressure.  High-yield and junk are risky assets thus prices have already reacted with the ETFs representing these segments (HYG and JNK) already hitting lows.  Additionally, some credit funds are shutting down.

The impact on emerging markets is clear what is unknown is the magnitude of the impact.  These markets have benefited from the easy policy of the FED with trillions flowing into emerging markets.  However, the flows have started to reverse.

In short, emerging market currencies will depreciate further.  The Chinese Renminbi has lost just under 2% in the past month and a half.  The risk is that outflows from China will result in increased market turbulence.

A good example of how this impacts emerging markets is the case of South Africa.  In the past month, the Rand has depreciated by 8% which means that imports will be more expensive.  This has increased the inflation rate thus prompting the central bank to raise rates.   If the Rand depreciates further, then there will be more inflationary pressure and potential action needed by the central bank.

There will be some market turmoil, but the extent will depend on 2016 expectations – how many more rate hikes and the magnitude of those hikes.