After seven years of near-zero interest rates, the Federal Reserve is expected to reverse its financial crisis-era stimulus measures on Wednesday and raise the short-term benchmark interest rate.
The move is widely anticipated after many Fed officials, including Fed Chair Janet Yellen, telegraphed confidence in improving U.S. economic conditions.
“I think the economy is on the road to recovery,” Yellen said at the Economic Club of Washington on December 2, 2015. She added that, if the Fed waits too long to raise rates, it would “likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals." The Fed has a statutory mandate of both maximum employment and price stability.
The Fed’s near-zero interest rate policy has fueled a massive 6-year rally in the stock market, as money searching for higher returns found a home in equities. This has enticed many companies to raise money through initial public offerings in the equity capital markets. Last year, companies raked in a record $85.2 billion in IPO proceeds, according to Renaissance Capital.
How are the markets likely to react to a rate increase?
Once the Fed increases its target for the Federal funds rate, the yield on other short-term loans will face upward pressure. This will, in turn, affect longer-term rates, such as mortgages and corporate debt. As bonds return higher yields, they become increasingly attractive versus stocks.
However, risky high-yield bonds may become less attractive, as a rate hike would exacerbate the ability of companies with distressed debt to borrow money. Problems in this area have already started to surface in the case of mutual fund, Third Avenue, which prevented investors from withdrawing money from its high-yield bond fund last week.
The shale oil sector is also likely to face headwinds, especially because many firms are unprofitable at current oil prices. Given the high capital requirements of these companies and limited lifespan of drilling enterprises, they must issue large amounts of debt and roll it over on a continuous basis.
Fed officials have explained that any rate increase will occur in a smooth and gradual fashion, so as to not create chaos in the markets and the economy. However, it is inevitable that the current bull market will end as the Fed ratchets up rates. Accordingly, the goal of the Fed is to mitigate market turmoil throughout the business cycle so as to provide what it consistently refers to as a “smooth landing.”