Investors have become paranoid about a possible hike in US rates, but if the Fed put up rates by a quarter of a percent will it really be the end of the world?
We think the panic being spread about US rate rises is being promoted by speculators and traders who have no interest in sustainable growth.
But with the US economy strengthening, evidence of a recovery in Europe, and the risk of asset bubbles, rising interest rates simply represent a much-needed step towards normalisation of the world’s monetary policy and economy. It isn’t to be feared.
Markets have been fed a diet of quantitative easing and low and negative interest rates for years now; indeed, we think they have become addicted to easy money. So perhaps it is not surprising that markets are now overestimating the risk of interest rate rises.
Figure 1. German stock index (DAX)
Source: Yahoo! Finance
But we think the bigger risk to the world economy is not rising interest rates, but excessive asset prices. As we have noted, the availability of easy money is manifesting itself in potential market bubbles. The Japanese market, for example, has high a 12-month high and the German market is at all-time highs.
The reality suggests that interest rates are going to have to go up in the next two years, not because of inflation surge, but because they are too low and are causing a bubble in equity markets and properties.
Back to normal
The US economy is also heading back to normal growth. The US has a strong economy, strong currency, great industry and technology, and powerful global consumer brands. Its robust economy is much more dynamic than Japan or Germany.
Figure 2. US Federal funds rate
Source: Board of Governors of the Federal Reserve System (US), Federal Reserve Bank of St. Louis
The corollary of that strength is that rates also need to normalise. A quick rise of rates to 2 per cent would have a jolting effect. But if the cash rate was to rise to 1 per cent to 1.5 per cent (and if 10-year bond yields rose to 3 to 3.5 per cent) we don’t think it would stall the American economy.
If those rates did kill US growth, then something would be seriously wrong with the global economy.
The Fed needs to ignore paranoia
The concern is that the US Federal Reserve will take the paranoia and panic over rising rates to heart.
The Fed is already trying to buck the trend and jaw bone the $US lower, which has seen the $A rise recently. (As an aside, we believe that gives Australian investors are chance to invest money offshore.)
But the Fed can’t let paranoia affect its judgment and create an asset bubble. It has already successfully ended quantitative easing without causing significant disruption to bond and equity markets.
Investors need to get used to higher interest rates in a year’s time. Rather than fear that, investors should embrace it as a welcome and much-needed start of a return to economic normalcy.