What Could a Rate Hike Mean for Portfolios?
- Recent shifts in the U.S. yield curve show that investors are sensitive to the Federal Reserve's communication about monetary policy and the anticipated impact of future rate hikes.
- We propose three scenarios for how markets could perceive the timing of policy actions: too much, too soon; ideal timing; or too little, too late.
- Potential implications for a diversified portfolio of global equities and bonds could range between -15% and +7%, and emerging markets may be more sensitive than the U.S.
Investors Are Revising Their Long-Term Interest-Rate Expectations
Investors' forward expectations on three-month interest rates at different points in time, as implied by the eurodollar curve. Source: Refinitiv Datascope
Three Hypothetical Scenarios for Rate Hikes
We define three hypothetical scenarios for how financial markets may perceive the future monetary policy path:6
- Ideal timing: Markets perceive that the Fed tapers asset purchases and hikes rates at the right time to keep inflation controlled while helping economic growth remain stable and robust. Investors are confident, equities gain and long-term rates increase slightly. Emerging markets benefit from strong U.S. growth.
- Too much, too early: Markets believe that policy actions occur too early and are overaggressive. Short- and long-term economic growth are negatively impacted, and market-implied inflation expectations drop. Equities fall, the yield curve flattens and the slowdown in the U.S. growth hurts emerging markets.7
- Too little, too late: Markets perceive that the policy path is too slow, which brings inflation worries to the forefront. While short-term growth is steady, long-term forecasts are hit. Higher inflation and a diminished growth outlook increase equity risk premia. Equities decline, while long-term interest rates pick up, resulting in a positive bond-equity correlation.
What We Assume in Our Scenarios
Scenario | Ideal Timing | Too Much, Too Early | Too Little, Too Late |
|---|---|---|---|
Scenario BEI-Rate Shocks (basis points) | Ideal Timing Two-year: -15 10-year: +5 | Too Much, Too Early Two-year: -85 10-year: -65 | Too Little, Too Late Two-year: +165 10-year: +115 |
Scenario Treasury-rate Shocks (basis points) | Ideal Timing Two-year: +30 10-year: +20 | Too Much, Too Early Two-year: +30 10-year: -40 | Too Little, Too Late Two-year: +30 10-year: +160 |
Scenario US Credit-Spread Shocks (basis points) | Ideal Timing Investment Grade: -15 High Yield: -40 | Too Much, Too Early Investment Grade: +40 High Yield: +150 | Too Little, Too Late Investment Grade: +45 High Yield: +190 |
Scenario US Equity Return (nominal) | Ideal Timing +13% | Too Much, Too Early -17% | Too Little, Too Late -18% |
Scenario EM Equity Return (nominal, in local currency) | Ideal Timing +20% | Too Much, Too Early -25% | Too Little, Too Late -23% |
Scenario EUR/USD Shocks | Ideal Timing 0% | Too Much, Too Early -7% | Too Little, Too Late +10% |
Implications for Multi-Asset-Class Portfolios
To assess the potential impact on multi-asset-class portfolios, we created a stress test using MSCI's predictive stress-testing framework and applied it to a hypothetical global diversified portfolio.8 Under the "ideal timing" scenario, most asset classes experienced solid returns with only sovereign bonds losing slightly, resulting in a 7% gain for the portfolio. The "too much, too early" scenario is the opposite image, with most asset classes losing and sovereign bonds providing some hedge against the setback. The portfolio loses about 12% in this scenario. In the "too little, too late" scenario, there's little place for investors to hide, as both bonds and equities decline, and the total portfolio loses about 15%. The exhibit below shows more granular results by asset class and region and for various base currencies.
The Scenarios' Potential Impact on Asset Classes
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U.S. Treasurys are represented by the Markit iBoxx USD Treasuries Index. The U.S. equity market is represented by the MSCI USA Index and U.S. investment-grade (IG) bonds by the MSCI USD Investment Grade Corporate Bond Index. Emerging-market equity is represented by the MSCI Emerging Markets Index. U.S. real estate is represented by the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. U.K. real estate is represented by the MSCI/AREF UK Quarterly Property Fund Index. The composite portfolio is represented by the following weights: 50% global equities (35% public and 15% private), 10% U.S. Treasurys, 10% U.S. Treasury inflation-protected securities, 10% U.S. IG bonds, 10% U.S. high-yield bonds and 10% U.S. real estate. Based on market data as of July 2, 2021.
Financial markets are sensitive to the Fed's communications about future policy actions — as well as their perceived timing and impact. The three scenarios outlined in this blog post could help investors gauge a range of potential outcomes and how they may affect portfolios.
Further Reading
1Platt, Ethan. 2021. “Hawkish Federal Reserve forecasts jolt Treasury market.” , June 16, 2021.2Note that we do not state an opinion about the Fed should hike rates. Instead, we define stress-test scenarios based on how markets might the timing and adjust prices accordingly.3Wigglesworth, Robin, Stubbington, Tommy, Smith, Colby, and Hume, Neil. 2021. “Reflation trades pummelled as Fed shift resets markets.” , June 18, 2021.4According to MSCI data, 10-year breakeven inflation dropped from 2.64% to 2.42% between May 12 and June 15.5Politi, James, and Smith, Colby. 2021. “Fed signals first rate rise will come in 2023.” , June 16, 2021.6The shocks in these scenarios are not meant to be instantaneous, rather on a medium horizon of a half year or slightly longer, as changes in the market take time to materialize.7Engler, Philipp, Piazza, Roberto, and Sher, Galen. 2021. “How Rising Interest Rates Could Affect Emerging Markets.” IMFBlog, April 5, 2021.8The results are generated based on this methodology, using MSCI's BarraOne®, whereby we used current correlations to propagate the shocks to a hypothetical multi-asset-class portfolio. MSCI clients can access BarraOne® and RiskMetrics® RiskManager® files for these scenarios on the client-support site.
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