The nice lady spoke.
She said what the market didn’t want to hear.
The market reacted. Stocks fell.
Haven’t they learnt anything?
She may be a nice lady, but you can’t trust a single word she says…
The market was waiting for this day.
It was the first time that new US Federal Reserve chairman, Dr Janet Yellen would take the helm of the central bank after taking over from that bad man, Dr Ben S Bernanke.
What would she do?
Would she junk everything the old doctor had done, or would it be business as usual?
It depends whether you believe a word any of these central bankers say. Based on history, we don’t believe it. But we’ll play their game for now.
So, what was the big story that the market disliked so much?
Well, it turns out that the Fed board members believe interest rates will rise sooner than expected.
Previously, the board members thought that interest rates would reach 0.75% at the end of 2015 and 1.75% at the end of 2016.
Now they’ve changed their view. The new forecast is for rates to be 1% at the end of 2015 and 2.25% at the end of 2016. That would be a big jump seeing as the current Fed Funds Rate is 0-0.25%.
The question is whether that will really happen.
We have our doubts.
For a start we look at the situation in Japan. Japan has held its interest rates at close to zero for 20 years. Several times over the past 20 years it has made ‘threats’ to raise interest rates.
When it has tried, the stock markets haven’t liked it – stocks have fallen. And on the currency front, the yen has climbed – that’s because the carry trade is less attractive if Japan’s interest rates are higher.
So each time the Bank of Japan has tried to raise interest rates they’ve quickly reverted to the zero interest rate policy.
Why would things be any different with the Fed and its interest rate policies?
Well, there is one reason…
We’ll say straight up that our position remains the same as it has for most of the past three years – US interest rates aren’t going anywhere.
That’s why we’ve held such a bullish position on stocks. Low interest rates are good for stocks for two reasons. First, it means the cost of borrowing is low for businesses.
It means they can borrow more money in order to reinvest in and grow their business.
But it’s also ‘good’ for investors who want to borrow cheaply to leverage into stocks and housing.
The other consequence of low interest rates is that it forces investors to buy riskier assets. Where previously an investor in the US may have earned 4% or 5% from a bank deposit, they’re lucky to get 0.4% today.
So they have to buy assets with higher yields. That mostly means buying stocks.
But if interest rates go up, that could be a problem for stocks. If an investor can get a better return from a safer investment like a bank account then it makes them less likely to buy shares.
That would result in lower stock prices.
But is that the only outcome of higher interest rates?
Not necessarily. Remember that a big part of investing is investor psychology. What do we mean by that and how could it impact stock prices?
It’s like this…
This is an argument we’ve made over the past year as the stock market rallied even though the Fed signalled that it would cut back on its bond buying program.
After all, the inference of cutting back the bond buying program is that interest rates will rise. So why would stocks go up?
That’s where investor psychology comes in. If the market believes that rates will only go up if the economy is back in shape, then that will give investors a reason to buy stocks.
They’ll believe that the Fed would only do something as radical as raising interest rates if businesses and consumers could cope with the change.
Does that mean money printing works?
No. Not at all. Money printing doesn’t ‘work’. It simply prolongs a problem and ensures that there will be another financial meltdown in the future.
But in the short term it gives the impression of working. That helps explain why the US S&P 500 index is up 153% since the 2009 low.
The important issue is whether this changes anything from an investment perspective. It doesn’t. When a central banker sends out a new message it’s natural that it rattles the market – hence the 0.6% fall this morning.
But long term (as in the next five years), nothing has changed. Interest rates are low, and they’ll still be low even if the Fed begins raising interest rates.
Just look back at 2004. The US Fed sent a clear message that it would raise rates. It did, again, and again, and again. And what do you know? The stock market kept going up because investors believed that the economy was in good shape – even though it was just masking the problems that would blow up in 2008.
Cheers,
Kris+
Special Report: Mining Boom Act II