When Rates Go Up, Markets Will Go On A Bumpy Ride

by: David Frank


As global central banks exit their current monetary policies, investors will want more assurance than what they can be given and this will send markets on a merry ride.

Last week, the FOMC further reduced their QE program by $10 billion a month to $35 billion.

There is talk the Fed could raise rates sooner than we expect.

There have been many concerns regarding how the ultra-easy monetary policies being implemented by the world's central banks is effecting the global economy. There are also concerns how these policies will affect the global economic recovery. Now, there is another concern, just over the horizon, which can throw financial markets for a loop. That is the impending raising of interest rates.

As central banks like the Bank of England and the U.S. Federal Reserve, begin the process to normalize rates by tightening their monetary policies, we could see the creation of a vicious circle. In other words, no matter how good their communication efforts are, the exit from an easy monetary policy is likely to be a bumpy ride. It could make market participants want more assurance than what these central banks can communicate or promise. This will lead to more risk taking. In turn, this will plant the seeds for a sharper correction than what we are expecting. Even if the central bank is aware this is happening, it will be boxed in with the fear of causing the very sharp correction in the financial markets they wish to avoid.

Since the global recession began in 2008 global central banks have been slashing their main lending rates to near zero, a move that is designed to stimulate borrowing and cash flow. Several banks, like the Federal Reserve (Fed), Bank of Japan (BOJ) and the Bank of England (BOE) have also enacted huge quantitative easing (QE) programs, a policy in which they buy government bonds to push yields lower. This allows them to borrow money at more favorable rates. The Fed is in the process of ending its QE program and investors are starting to expect them to normalize rates soon. As in soon, I mean by middle of 2015, even though St. Louis Fed Chief James Bullard has hinted rates could go higher sooner. Last week, they further reduced their QE program by $10 billion a month to $35 billion. They hope to end this program by October or November of this year.

Meanwhile, the BOE has confused financial markets as to exactly when they will normalize rates. This confusing message has sent the London FTSE on a merry ride thanks to mixed signals. However, despite these confusing messages, things can get a lot worse if these central banks decide to delay their return to a more normal monetary policy. They are playing a delicate game and must be careful not to be too gradual or too late.

History tells us a story, there will be economic and political pressures pushing policy makers to delay or stretch the exit from an easy monetary policy. The benefits from staying with easy policies, while tangible in the short term, will wreak havoc over the long term as the costs will increase over time. This has happened in the past, and history tends to repeat itself.

The effects of ultra-loose policies has warped economies. It has separated economies that were greatly affected by the global recession and those that continued to grow. Economies that were badly hurt should be fixing balance sheets and starting on structural reforms. Those economies that were not adversely affected and grew, should be looking at ways to curb their "boom economies." These economies should also be looking at ways to strengthen their defenses if they should experience a financial bust.

Because rates have stayed so low for such a long time, there is very little room to maneuver and make adjustments. This is more so for countries which have been in an economic boom for a longer period of time. The tradeoff here is simple: it lies between the risk of bringing on the downward leg of their economic cycle now in order to manage a soft landing, or they can delay and suffer a bigger economic bust later down the road.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.