The U.S. Federal Reserve is on the verge of raising short-term rates for the first time since the global financial markets crisis hit seven years ago. However, there remains considerable uncertainty about how well the Fed will fare in managing the exit strategy from its low interest-rate policy. Uncertainty about economic growth and inflation has become a central question for investors and policy makers, with crucial implications for the Fed’s exit strategy and investor portfolio returns.
We applied the MSCI Macroeconomic Risk Model and Risk Manager to stress test three possible exit scenarios and quantify their impact on asset class factor and global multi-asset class portfolio returns. The three scenarios comprise:
- Too early, too aggressive. Rate hikes occur too early and appear to be too aggressive. This scenario could kill the current recovery, potentially sending the U.S. economy into a deflationary recession. Bad for equities, good for long bonds.
- Too little, too late. The Fed waits too long and does not raise rates quickly enough. Inflation could surge, leading to a recession. Bad for equities, bad for bonds.
- Ideal timing. The Fed raises rates in sync with a recovery, implying a return to pre-2008 growth rates with modest inflation. Good for equities, bad for bonds.
We applied the three stress tests to a balanced global portfolio of equities and bonds. Depending on investor expectations, the impact could vary widely. For an unhedged, U.S. dollar-denominated portfolio, the too little, too late scenario is the most severe, with a potential decline of 6.6%. The ideal timing scenario could produce a 1.1% return, while the too early, too aggressive scenario could generate a slight loss of 20 basis points.
Applying these stress tests to a hedged, U.S. dollar-denominated portfolio could produce quite different results. Using that portfolio, the too early, too aggressive scenario could have the worst result, producing a decline of 3.2%, while the too little, too late portfolio could drop only 1.9%. In contrast, the ideal timing scenario could result in a rise of 2.4%.
Fed rate hike stress test results
The results represent the market impact of the Fed rate hike stress test. While the macroeconomic indicators develop over a one-year horizon, markets reaction typically occurs much more quickly.
Read the paper, "The Fed Rate Hike."