SI Férique

 August 8, 2013

 Interest rate normalization could be a good thing


Probably the biggest driver of global equities markets during their rebound following the recent recession has been exceptional low interest rates. The resulting cheap borrowing costs, sparked by the actions of the US Federal Reserve and other major central banks, are like economic tonic. They make it easier for consumers to buy stuff and businesses to invest, pay off their debts and buy back their own shares.


In the United States stocks have been exceptionally strong with the S&P 500 and Dow Jones Industrial Average both hitting record levels recently. This occurred despite merely lukewarm support from another key valuation pillar, a strong and growing economy.


That said, loose monetary policy will not last forever. Global central bankers are acutely aware that unprecedented short term interest rate cuts, and non-traditional actions such as the Fed’s Quantitative Easing purchases of medium term securities entail considerable risks. These include mispriced assets and possible inflation down the road. The Fed for its part has been hinting that it would soon moderate stimulus, by “tapering” its bond buying program.


Markets have responded. Yields on longer dated US bonds have been gradually creeping up. During the first seven months of the year, interest rates climbed by 84, 84 and 70 basis points respectively on seven, 10 and 30 year notes. Fallout from this process accelerated in June after the Federal Reserve hinted that it could begin “tapering” its bond buying.  That said, those gradually rising interest rates south of the border may not necessary be a bad thing.


True, they will hit the country’s household sector, which has been gradually bouncing back. Many US regions have recently recorded double digit price increases for the first time in a while. This is good news because strong home sales tend to drive ancillary purchases such as furnishings, renovations and accessories. Canadian businesses also win big, because the US is our largest export market and sales there generally account for more than a quarter of our Gross Domestic Product.


However before panicking at possible increases in Federal Reserve’s policy rates, it pays to remember that the monetary authority’s key executives have attached hard employment and inflation targets that need to be hit before that is to occur. That means if the Fed starts raising rates, it will be because the economy is going great guns and has good prospects going forward.


Right now it is unclear how this will play out. Job creation numbers have been week compared to what we should be seeing at this juncture in the cycle. Although the 162,000 jobs were created in the United States in July, and the unemployment rate fell to 7.4 percent, those numbers were below expectations. That was slightly below the 189,000 per month average pace in non-farm job creation over the past 12 months.


While that pace seems impressive, it is just barely enough to keep up with US labour force growth. Worse, a far higher proportion than normal of those new jobs are part-time, as companies south of the border, attempt to avoid paying expensive benefits (notably healthcare costs), to new workers.


However if the Federal Reserve were to start tapering its asset purchases, it would provide a strong signal to markets that the US economy is starting to get enough momentum to run on its own two feet. Over the long term, strong domestic demand and underlying economic fundamentals would be far more favourable to a long term market outlook, than government printing presses working overtime.


In short, gradual upwards movement in interest rates in the United States and its major partners, such as Canada, might not be a bad thing.                  




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