The likely effects of a US interest rate hike on global markets – a guest post

The US economy has been on a revival path for quite some time. The Quantitative Easing programme to stimulate a sluggish economy was gradually tapered off last year. With inflation showing signs of inching up, the stage is getting set for a possible interest rate hike by the US Fed.

Why should that be of any interest to Indian investors? Because the global economy has become a lot more interconnected. A rate hike in the US, coupled with a strong Dollar, may be a signal for FIIs to withdraw money from emerging markets (including India).

In this month’s guest post, Nishit discusses the current economic scenario in the US, and the possible effects of an interest rate hike on world markets.

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World markets were on tenterhooks – awaiting the US Fed announcement of a possible interest rate hike. Why are markets so obsessed with the US Fed decision to hike rates and how does it affect world markets?

The US Fed’s answer to the 2008 economic crisis was throwing cash to plug the gaps. They printed money and called it ‘Quantitative Easing’. Large amounts of money were made available at very low interest rates. This money found its way into many emerging markets, like India, and boosted their stock markets.

The idea was simple: borrow in the US at almost zero interest rates, invest in stock markets worldwide and mint profits. Since the rate of interest was almost zero, the currency risks were taken care of.

Quantitative Easing seemed to have worked and the US economy in the past 2 years has shown signs of recovery and growth. It is no more in recession, jobs are being added and the crutches of stimulus are no longer needed.

The US Fed had to account for this surplus printing of money and as a first step they tapered off the Quantitative Easing programme.

The next step is to hike up the interest rates as easy money can lead to inflation and creation of bubbles. Low interest rates helped to provide stimulus to the economy. Now, when the economy is up and running, the rates have to go up gradually for two simple reasons.

First is to prevent the formation of economic bubbles, and second is to provide room and buffer for providing another stimulus if the economy goes into recession again. After all, one can cut rates only up to zero.

In an isolated scenario this is fine. But in the case of the US - since it is the global leader - this extra money has been invested into various asset classes across the world. If the Fed starts hiking rates, then this money may be withdrawn from the various asset classes and will flow back to the US. The US Dollar has already started strengthening in anticipation of this.

Such a situation can lead to recession in other parts of the globe. Since the global economy is interconnected and the US companies also get a major part of their income from places other than the US, the Fed needs to tread cautiously.

To counteract the likely US withdrawal of stimulus, we have the Japanese stimulus and now the European Central Bank stimulus.

This is one of the anticipated reasons our markets are falling. One needs to keep an eye on how this plays out.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan. You can reach him at nish.stockid@gmail.com)

Notes from the USA – a guest post

For the past 4 months, FIIs have been net buyers in the Indian stock market while DIIs have remained net sellers. QE1 by the US Fed had released a flood of liquidity in global markets that led to a strong bull rally from early 2009 to end 2010.

QE2 had less of an impact on the Indian stock market, but helped the US market to scale new highs. Now QE3 has finally come along, and perhaps in anticipation, FIIs have been in a party mood. Despite all the liquidity flow, the underlying economies in US and Europe have remained weak while China and India are in the midst of slowdowns.

In this month’s guest post, KKP explains some of the new financial terminologies and the ‘fiscal cliff’ that the US will be confronting soon. He also suggests a course of action for small investors. 

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QE3 and Fiscal Cliff – New Vocabulary for our World!

We learned a lot of new words from Greenspan, and in recent years, we have started to hear about Quantitative Easing…LSAP…LTRO from Fed and Central Banks. What does all this mean to us as small investors in the US and India?

Well, LSAPs are Large Scale Asset Purchases that the US Government started in 2008 to create a balance under special circumstances. EU’s version of the same is called LTROs, which are Long Term Financing Options. Both of these flavors are nothing but a method of pumping fiat money into the economy at the discretion of the Fed/Central Bank to create a balance where they determine the situation/environment has created an imbalance. Of course, it is done with a controlled private risk.

The unusual situation is that in the last 50+ years, the primary tool of monetary policy has been the Federal Funds rate. During the recent crisis, however, the Federal Reserve unveiled a variety of new policy measures never used before. What forced its hand initially was the disruption of credit markets in the wake of the deterioration of the subprime mortgage market, which began in August of 2007. By February of 2009, however, a second factor came into play i.e. the Funds rate effectively reached its lower bound (zero), implying that despite the severity of the recession, the conventional option of reducing the Funds rate was no longer available as the common Fed weapon. Fed kept giving solace to the markets that the future path is zero rates for Fed Funds, but had to come up with these special measures to combat and stimulate the economy.

Shortly after the meltdown that followed the Lehman failure in September 2008, Fed initiated QE1, which was purchase of a variety of high grade securities, including agency mortgage backed securities (AMBS), agency debt, and long term government bonds, with AMBS ultimately accounting for the bulk of the purchases. It also set up a commercial paper lending facility, which involved the purchase of commercial paper since the Fed accepted these instruments as collateral for loans made to the facility. In October 2010, the Fed announced a second wave of asset purchases (QE2), this time restricted to long term government bonds that was smaller in scale than QE1.

Finally, in September 2012, the Fed embarked on QE3, specifically targeting mortgage bonds in particular, on the grounds that lower mortgage-bond yields will feed through into lower mortgage rates, which in turn will feed through into healthier housing prices, igniting jobs. In short, the Fed is not trying to kick-start the economy any more: instead, it’s promising a steady extra flow of monetary fuel for the foreseeable future — or at least until the labor market improves “substantially”, which is likely to be a pretty long time. I kid you not, this is a large deal by itself since they have all but promised a zero interest rate environment until mid-2015 with a $40B per month funding out of QE3.

In short, the Fed has already pumped a lot of money into the economy, has already put interest rates at subterranean levels at this point and if those interest rates aren't low enough now to get people to borrow money, it's not totally clear to anyone that it is guaranteed to have the desired huge effect going forward. Ben Bernanke is making a fairly simple bet that a stable stock market is going to be better for the economy than a collapsing stock market, and lower mortgage rates are going to be better than higher mortgage rates at this point. And he's hoping that all of this will boost confidence and give people more money to spend, which in the end can boost job creation.

There's some evidence to support both of those points, but he also seems to realize that this isn't going to really solve all problems. In his commentary carried live on CNBC and Bloomberg, he was very clearly pointing out that Fed can't fix our underlying problems with any guarantee, but will be fully supportive in doing whatever it needs to do. Central Banks in EU are pretty much convinced of making similar moves, and getting similar results. For now, EU is getting support from the investment community, in a similar manner to that in the US.

In the short term, I am expecting to see higher stock markets in EU and the US – probably till November (US elections). I will then look for signs in the economy that will show deterioration in the under-current of the economy (tax dole-outs/receipts, housing, manufacturing, welfare programs, import/export, retail sales, big-ticket-items, leading-indicators, unemployment, corporate revenue/earnings, and of course the insider trades). The biggest of all will be the “Fiscal cliff” - which is the popular shorthand term used to describe the conundrum that the US government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

These laws have to do with the 2001-03 tax-cuts, taxes related to Obama Health Care, 1000+ government program cuts and other elements. We’ll definitely get events from Central Banks in EU as well as the Fed that will shake the perception of the investment community. If all of that is not enough, remember that the first year of a new president is always a down year, since there are no promises of the ‘better world’ (mostly given during the election year). So, between now and November, going long might be OK, but get ready for going to cash or short after that in most global markets.

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

Notes from the USA (Sep 2011) - a guest post

Every one was expecting - or may be hoping - that Ben Bernanke would do something different to jump-start the US economy, after the failure of two rounds of Quantitative Easing. In typical Bernanke style, he had already taken much of the surprise element off the table by hinting at an Operation Twist. But when the actual announcement was made, global markets reacted negatively.

What exactly is this Operation Twist? Here is KKP's spin on it.

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Is the Fed Twisting the Future?


The US Fed announced Operation Twist.  What is the Fed ‘twisting’?  Most people that I have talked to (average Americans), do not even know this stuff was announced and going on (poll based on discussions with my neighbors at a party on Sat. Sep 24 ‘11)!


Basically, the Fed never does anything that affects the long term bonds or bond rates.  Rates are already so low that for those who wanted to refinance, they have already done so.  Fed always assumes that when it lowers the short term rates (which is the only thing in its control), the banks will react to the message that goes along with the rate change (at the FOMC meeting), and adjust the mortgage rates which are linked to the Prime Rate (usually).

The Fed also said that when mortgage-backed securities (MBS) that it owns right now is paid off, it will roll the money back into new securities that are linked to mortgages.  This means, it is also now trying to affect the mortgage rates, which would also go down with this move so that people can lower their mortgage payment (EMI) and spend the extra cash flow that they have received (and people here in the US sure do so).


The idea being that with lower interest rates on housing (long term rates of 10, 20, 25, and 30 year mortgage terms), people who are thinking about upgrading their homes would start going after a bigger loan and buy new homes.  Once the housing boom starts, there are tons of businesses that get the support needed and, hence revive the economy.   Homeowners who have a lot of home equity and are current on their mortgages may also be given an opportunity to refinance, freeing up cash flow that could be spent on buying a car, upgrading the home, and/or paying off other high interest loans.

The issue is that lower interest rates, or lower price of homes has not really triggered a buying frenzy.  That is because of two reasons.  First, banks are scrutinizing loan applications with a super-high-standard.  Everything has to be too perfect on the loan application, and any small element that points to risk, means that the loan officer rejects the loan.  Second, people who need new houses, and have one (or more than one) family member that may not have a job, or might have a weak job-income, or might not have the feeling of being secure in their current job, do not go out and make a big house commitment.  

A case in point is a single woman with a good job who wanted to buy a $325,000 home with $50,000 down payment, and $275,000 in loan was denied.  This is according to one of our neighbors who is livid about how the banks have tightened their purses for some unknown reasons.  Corporations, Banks and People (who have cash), are all ‘holding back’ due to the unknown future.  This is actually creating a ‘bigger’ issue than what it would really be.   So many of us are living normal lives in this recessionary environment, but we all have a fear of the future, which is what makes all of us spend less, conserve more, and wait for a brighter day (my personal situation is different, since I am capitalizing by buying real estate, which is exactly what the government is trying to do by keeping short term interest rates near zero).


Fed wants banks to loan money, which is why they had provided the TARP funding.  A lot of the TARP funding is being returned by the banks.  There are announcements that show this return of funds that is on-going, and even a couple of bank VPs told me this in confidence.  They are afraid to tap into it, loan the money, and lose profits (and capital) by loaning it to someone, specially if the economy gets worse.  In reality, the central bank requires banks to keep a certain level of reserves on deposit at the Fed.  Legislation passed in 2006 permitted the Fed to start paying interest on those reserves starting in 2011.  This requirement of reserves and ratios by the Fed makes the loan officers reluctant to give out loans to people with the smallest risk.

Group of 20 finance chiefs are pledging to address rising risks to the global economy and are “committed to a strong and coordinated international response to address the renewed challenges facing the global economy,” confirmed in a statement in Washington.  These officials cited “financial system fragility” and “heightened downside risks from sovereign stresses” among the threats to growth.  They said they will ensure banks are adequately capitalized and have access to liquidity, while reiterating an aversion to volatility in the currency markets.  This support model is what we need to keep our world spinning and continue e-commerce for the world to survive.  It is amazing that we are fearing a collapse when there is everything in abundance!


So, all in all, what is the ‘twist’ in the Operation Twist?  The twist really is that the Fed is trying to affect long term rates or mortgage rates without really dipping in any huge way into a QE3, which would have affected how investors around the world view the US.


Daniel Gross’s Upshot View: This move by the Fed is better than doing nothing. But there's no reason to think it will make the difference between unsatisfying and satisfying growth.   
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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.