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Fed ready for lift off

After years of ultra-loose monetary policy, global financial markets believe the U.S. Federal Reserve is probably all set to raise interest rates for the first time in almost a decade.

After years of ultra-loose monetary policy, global financial markets believe the U.S. Federal Reserve is probably all set to raise interest rates for the first time in almost a decade but it will not likely have a profound effect on private equity deals, especially in the middle market.

Aurigin (formerly BankerBay) CEO, Romesh Jayawickrama, isn’t worried about the timing of a rate increase.

“The start of the rate hikes is not the most critical factor because it’s going to be relatively soon. Whether they move by a marginal amount in December or January or the next FOMC meeting isn’t the point. The longer term point is that interest rates cannot be maintained at this level for a great deal longer and certainly not infinitely longer,” he said.

The FOMC had laid down certain conditions before embarking on a rate increase, such as the long-term unemployment rate declining below 5.2 per cent and inflation staying at 2 per cent. The October jobs report showed unemployment fell to 5 percent from 5.1 percent in the previous month. Coupled with the inflation rate well within the comfort level at 0.2 percent in the 12 months to October 2015, it has somewhat cemented expectations for an interest rate hike at the December 15-16 monetary policy meeting. Furthermore, a healthy increase in non-farm payrolls in November supports the case for an interest rate increase.

Also, in October, Fed Chair Janet Yellen indicated a move before the end of the year was a “live possibility.” Other Fed policymakers have since followed suit, flagging December as the month when interest rates will likely go up for the first time since 2006.

In fact the last time the central bank tinkered with the Fed funds rate was back in December 2008, when it cut the base lending rate to a range of 0-0.25 percent. But more importantly, it has injected over $3.5 trillion, roughly the size of the German economy, into the banking system through its quantitative easing program, which came to an end in October 2014.

Besides hiking interest rates, the Fed also has the onerous task of trimming its balance sheet that has bloated following the QE program. The assets of Federal Reserve were $865 billion in August 2007. This expanded to $4.4 trillion by the end of July 2015. While there is no roadmap on selling the long-term securities purchased from banks and other institutions yet, once the Fed begins selling them, U.S. treasury yields are going to shoot higher, causing another round of exodus from emerging market bonds.

The near-zero rate of interest in the U.S. since the end of 2008 has resulted in companies borrowing in dollars at close to zero to buy financial assets across the globe or to lend to borrowers in other countries.

As the era of cheap money draws to a close, asset prices across the globe are likely to be impacted. There is likely to be selling in many riskier assets as investors pull money out to repay the dollar loans and to repatriate money to safer havens. These outflows will, in turn, make currencies depreciate, impacting global trade and eventually economic growth. In fact there are some indicators that already present a cause for concern and have driven the debate in financial markets from the timing of the first increase to the path the Fed will take.

“Because the global macro events (both economic and political) are so unpredictable, very dynamic and have  a large influence around the world, if the Fed does  increase rates in December, does that mean it’s going to be a perfect rate hike gradient from now on, not necessarily,” Jayawickrama said.

“I don’t think the U.S. can afford to move too aggressively. There are still too many weak indicators. It’s not just the U.S., it’s the rest of the global economy that is something to consider. If China continues to slow down, there are a lot of consequences from that to the rest of the world and of course the U.S. ”

Chinese authorities are trying to rebalance the economy away from reliance on exporting manufacturing goods toward domestic consumer spending and worry about a Chinese growth slowdown was one of the main reasons cited by the Fed for holding off at the October meeting. Indeed, the fact the Fed placed so much of its emphasis on China as a risk left many concluding that prospects for a rate hike had faded away.

And if China shows other indicators of a more aggressive slowdown, the U.S. will think very heavily about not being too aggressive. That, according to Jayawickrama, is one of the biggest macro factors right now.

More importantly, he is also looking at the implications for private equity deals. Any small increases will not likely impact the private equity space and deal flow will continue to remain strong.

“We are coming off a really low interest rate base. The cost of debt is still exceptionally cheap so even if they increase rates by a relatively significant amount, in real terms it’s still very cheap money. I don’t think it’s going to make a massive difference until we see significant increases in the cost of debt and that will happen over a period of time, maybe many years I would say, depending on other macro global conditions,” he added.

“We’ve already seen a significant increase in M&A globally in 2H15, and on Aurigin our deal flow data very much supports this. If debt is likely to start getting more expensive, it may make sense for firms to accelerate their acquisition strategies to make the most of the shorter end of the yield curve,” he explains further

Will 2016 be the year for M&A or will PE stand its ground? A lot will depend on not only a rate increase, but the periodicity and size of continued increases and is likely the factor to watch out for next year.