The US central bank’s decision to increase interest rates for the first time in nearly a decade signals confidence in the economic outlook, says Michael Grady.

Key points

  • The US Federal Reserve has increased interest rates for the first time in nearly a decade
  • Financial markets have reacted calmly to the move, which was widely expected
  • We anticipate the Bank of England could hike rates in the middle of 2016
  • Gilts may weaken ahead of this. But UK equities should benefit from a strengthening UK economy
  • A sharper-than-expected slowdown in emerging economies poses the main risk to our outlook

Global financial markets have responded positively to the increase in the range for the Federal Reserve’s benchmark interest rate to between 0.25% and 0.5%, from the previous range of 0%-0.25%.

Although the move had been widely anticipated by investors, the lifting of uncertainty prompted a rally in US, European and Asian equity markets. The hike signals policymakers have confidence in the outlook for the US economy following the long and steady recovery from the financial crisis. Janet Yellen, the Federal Reserve’s chair, said the process of raising interest rates is likely to proceed “gradually”.

The UK is facing a similar economic outlook – robust domestic demand growth, a tightening labour market and an expected increase in inflation. If this continues, the Bank of England is likely to raise interest rates around the middle of 2016. That could result in some weakening in gilts, particularly short-dated gilts, which are currently pricing in an exceptionally slow pace of hikes in the UK. However, UK equities should remain supported if we see continued strength in the US and UK economies along with a stabilisation in the euro area. The impact on the UK real estate market of the increase in US rates is likely to be limited, with domestic developments over the coming year of more relevance.

Risks remain however. Prominent among them is the danger of a faster slowdown in China and other emerging economies. That could dampen global economic growth and inflation, which would be more supportive of bonds and less positive for equities.

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