There are many consequences to the Federal Reserve’s zero interest rate policy and quantitative easing. A major one that is underappreciated is just how focused financial markets are on every utterance coming from the Fed’s board members.
This hyperfocus has come about because the cheap money — created by the Fed — has been used for investment speculation. If the cost of the cheap money to the speculators starts to rise, they need to unwind their trades. Hence, the focus is on all utterances by the board members, especially those of Chair Janet Yellen, now that the discussion is about interest rate increases.
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There has been an uncanny correlation between the move higher in the stock market and the implementation of the three rounds of QE. During the time when the Fed was actively implementing each round the stock market moved higher. When each round stopped, the market traded down or sideways until the next round began. QE 3 ended in October 2014 — if you look at a graph of the Standard & Poor’s 500 index, you will notice that the index peaked at 2,089 on Dec. 22, 2014, and that is about where the market trades today, a year and a half later.
Accordingly, the Fed has placed itself in a box where markets trade more based upon anticipated monetary policy than based upon financial fundamentals.
In an interview on May 27, Yellen said a rate rise in coming months is probably appropriate, so I think we can anticipate the Fed will raise rates this summer. What could it mean and what could be the consequences?
We should first look at the possible timing. The next Fed meeting will be June 14-15. It is unlikely it will raise rates at this meeting because Great Britain votes on whether or not to leave the European Union on June 23. It’s doubtful that they will vote to leave, but if they do, it will be very disruptive to world markets.
Consequently, it is very unlikely that rates will be raised prior to knowing the outcome of this vote. The Fed’s next summer meeting is July 26-27. This is the likely time a rate hike will be announced because the following opportunity is the end of September. The September date is too close to the presidential election and the Fed would not want to be seen as being political.
What are the possible implications of a rate increase? Raising rates is actually a healthy thing. It would show the Fed has some faith in increased economic growth, as well as moving toward a more normal position. What is very unusual is that as low as interest rates are in the U.S., these rates are currently the highest in the developed world. The European Central Bank and Bank of Japan have orchestrated interest rates that are less than zero (negative interest rates).
We have to remember that when the Fed talks about raising interest rates it is essentially referring to the overnight borrowing rates between banks. The question becomes: If it raises the overnight rate will it cause longer-term bond rates to go up as well?
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It will not, as European and Japanese investors will continue to buy U.S. bonds because of their yield advantage. For example, a Japanese government bond that matures in 10 years has a yield of -0.24 percent. A U.S. 10-year government bond pays 1.85 percent. German 10-year government bonds currently yield 0.20 percent.
The effect of a rate increase on stocks will be different. A rate increase likely causes the dollar to move up in value, which creates a headwind for the large multinational U.S. companies. A stronger dollar hurts their overseas earnings. When you couple this with the uncertainty of the U.S. presidential election and the historical weakness of the May to October time frame, investors need to prepare for a volatile summer in the stock market.
Central banks around the world are still trying hard to stimulate economies through cheap money, and this usually is very good for stocks. However, the stimulation is also causing a lot of distortions — the unwinding of which can’t be predicted. If investors are in the stock market they really need to have a long-term view and conviction to hold through negative corrections, or a strategy in place to take protective action in advance.
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The ingredients for large negative corrections exist and reacting by selling after they occur is usually the wrong move.
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The Consequences of a Summer Interest Rate Hike originally appeared on usnews.com
