Interest Rates & Markets: Pondering The Consequences Of Uncertainty

Includes: DIA, SPY
by: FP Trading Desk

What are the world's central banks going to do next with interest rates? Economists and investors are growing increasingly befuddled by this question, and their head-scratching could lead to bigger ups and downs in financial markets.

The uncertainty over interest rates represents a major shift from recent years, when the next moves from most central banks were clear as day -- partly because of the language of their monetary policy statements and partly because of their consistency in either raising rates or keeping them on hold.

The U.S. Federal Reserve maintained interest rates at 1% for a full year until June 2004, always assuring its growing audience of policy wonks that the low rates were necessary to support economic activity and combat the threat of deflation. Then the central bank embarked upon a rate-raising campaign that was equally steady: it raised rates 17 consecutive times between 2004 and 2006, always by a quarter of a percentage point. Its language pointed to solid economic activity and the potential for rising inflation pressures.

Knowing where interest rates were headed was simple -- and profitable. The consistency of central banks made it relatively easy for investors to get a handle on where bonds prices and corporate profits were headed. No wonder the stock market thrived.

The future is far less certain now, and nowhere is this more evident than in the United States. There, stubbornly high inflation and a persistently deteriorating housing sector have created conflicting views of where rates should go next: up (to kill inflation) or down (to rescue the housing sector).

"Those two outcomes are diametrically opposed, which is one of the reasons why there is so much interest rate uncertainty in the market," said Douglas Porter, deputy chief economist at BMO Capital Markets.

"You can see it almost on a day-by-day, and certainly on a week-by-week, basis in the treasury market. One week, it looks like the world is coming to an end with a massive rally in treasuries, and the next week it's more like 'What were we thinking?' and yields shoot higher again on concerns about inflation," he said.

Bonds are not alone. Stocks are turning more volatile as well, as measured by the Chicago Board of Options Exchange volatility index (or VIX) for the S&P 500. The index shows volatility has recently spiked higher, with investors dumping stocks one day and scooping up apparent bargains the next.

The Dow Jones industrial average, for example, has suffered six triple-digit losses since the start of June and enjoyed three triple-digit gains, ending the six-week period just about where it started.

In Canada, there is slightly less uncertainty over interest rates, given that the Bank of Canada raised rates this week by a quarter of a percentage point. But the future is still in doubt, with some economists predicting more aggressive hikes to come and others predicting that the work is more or less done. The bank's vague statement this week will only feed the debate.

If interest rate certainty helped feed the steady bull market in equities over the past four years, you have to wonder what uncertainty will do.

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