Base rates in the US have been held at a historic low of 0.25 per cent since December 2008. One consequence of this long period of near-zero rates is that some parts of the market have become extremely crowded.
Investors have piled in to blue chip equities which are considered similar to bonds, because of their low price volatility and regular, stable dividend payments.
These kinds of companies are very expensive to buy, and rising interest rates may remove the rationale for investing in them.
“There are a lot of crowded trades, particularly blue chip equities, and those are the most likely area for a sell-off,” says Peter Toogood from City Financial Investment, who has begun to move his portfolios away from shares he considers crowded rather than sensible.
“The ramifications are, if you are crowded into trades that rely on ever low interest rates and no growth – that part of the market is really vulnerable,” he adds. Some investors have highlighted other areas of the market which could be useful for income, such as convertible bonds and asset backed securities.
LIQUIDITY AND TIMING
Some managers have been flagging up crowded trades as a real concern, because the stock market is “woefully bereft of liquidity,” says Gareth Lewis of Tilney Bestinvest.
“When there is little liquidity in the market it takes relatively little to destabilise things.”
The impact of monetary policy changes on markets is difficult to forecast, but many people in city today simple are not used to an environment of tightening policy, explains Paul Niven, manager of the Foreign & Colonial investment trust.
"It has been 11 years since the start of the last rate hike cycle so a lot of people in the city have not seen a hiking cycle," he says. Niven believes the Federal Reserve will begin raising rates in September - several months before the current market consensus. "I think September looks most likely and that's not in the market... that's going to be a big deal for markets when the first rate hike comes."
The upside is investors have had time to prepare for the impact of rate rises, and bond markets have begun to anticipate policy change in the US, explains Nathan Sweeney of Architas.
“We are already seeing the bond market react in the re-pricing of Treasuries. In February a 10-year bond was yielding 1.6 per cent and we are now at 2.5 per cent – that’s a big move,” he says.
The next move could be institutional investors shifting into corporate bonds if their yields become higher than returns offered on equities.
The consensus view in the market is that there will be a small rise in interest rates of 0.25 percentage points in December. This is because data released from the US appears to show a broad recovery in everything from consumer spending to house prices.
“The funny thing about markets is that they have been very focused on Greece and what’s happening there, and have ignored the data that came out of the US last week,” says Sweeney. “The recent data has compounded the fact that the Federal Reserve is likely to raise interest rates this year.”
There are three meetings of the Federal Reserve Open Market Committee (FOMC) coming up, in September, October and then December. Many expect this will be a time when the FOMC digests the positive data before announcing a rate rise in December.
“But it is not going to look like the last decade when rates were risen 17 times in 10 years,” Samra says, adding that FOMC chair Janet Yellen has reiterated that monetary policy is going to remain very accommodative even after rate rises begin.
One of the problems with assessing the US economy is that the sheer number of metrics used can present a conflicting picture. Rate rises depend on an improvement in employment figures, and Yellen has said the labour market does not appear to be functioning normally.
There appears to be a high number of people now outside the labour market entirely. This could be because an effect called “economic hysteresis” is underway, where a deep recession disincentivises many people from returning to the labour market.
There is also the possibility the US jobs market has undergone structural change since the crisis. For example, increased automation in industry may mean there are fewer low skilled jobs available. This is difficult to measure, though. So while there are a lot of reasons to be positive on the outlook for the US, one of the most important indicators – the labour market – is still showing a conflicted picture.
“US employment data is a fallacy of comparison. The numbers appear to be going down but the way it is calculated means people who cease to be looking for a job cease to be counted, they fall out of the data,” Lewis says.
There is a similar problem with wage increases, which have not moved as quickly as authorities had planned.
Kully explains: “That depends on whether you look at the Average Hourly Earnings index or the Employment Cost index. In the latest report the former was showing just a little bit above consensus expectations whereas the latter was showing more growth than that.”
This leaves experts confused as to the real state of the American economy. Some are concerned the US may have to resort to another round of QE. This could come about if rises in interest rates hinder growth.
“There is a risk that, after a couple of rises in rates, that will be it... and there is a risk that if we have this discussion this time next year, we may be talking about whether the Fed will do QE again,” says Lewis.
The other risk to the US is a surprise bout of inflation, says Sweeney, although this is a leftfield event and not something on the horizon.
“The real risk comes from inflation coming back at a higher level than expected... that would put pressure on companies who have been buying back their shares on the stock market – something which has had a positive impact on share prices.”