Last week, both Janet Yellen of the Fed and Mark Carney of the Bank of England prepared financial markets for interest rate increases. The working assumption should be that this was coordinated and that both the ECB and the Bank of Japan must be considering similar moves.
Central banks coordinate their monetary policies as much as possible, which is why we can take the view we are about to embark on a new policy phase of higher interest rates. The intention of this new phase must be to normalize rates in the belief they are too stimulative for current economic conditions. Doubtless, investors will be reassessing their portfolio allocations in this light.
It should become clear to them that bond yields will rise from the short end of the yield curve, producing headwinds for equities. The effects will vary between jurisdictions, depending on multiple factors, not least of which is the extent to which interest rates and bond yields will have to rise to reflect developing economic conditions. The two markets where the change in interest rate policy are likely to have the greatest effect are in the Eurozone countries and Japan, where financial stimulus and negative rates have yet to be reversed.
Investors who do not understand these changing dynamics could lose a lot of money. Based on price theory and historical experience, this article concludes that bond yields are likely to rise more than currently expected, and equities will have to weather credit outflows from financial assets. Therefore, equities are likely to enter a bear market soon. The commercial and industrial property should benefit from capital flows redirected from financial assets, giving them one last spurt before the inevitable financial crisis. Sound money, physical gold, should become the safest asset of all ,and should see increasing investment demand.
Assessing potential outcomes of this new phase of monetary policy is a multi-dimensional puzzle. There’s the true state of the economy, the phase of the credit cycle, and the understanding, or more accurately the lack of it, of the relationships between money and prices by policymakers. This article is aimed at making sense of these diverse factors and their interaction. We start by examining the intellectual deficit in economic and price theory to improve our understanding of where the policy mistakes lie, the resulting capital flows that will determine asset values, and therefore the likely outcomes for different asset classes.
Interest rate fallacies
The most egregious error made by central banks and economists alike is the assumption that gradually raising interest rates acts as a brake on the rate of economic expansion, and therefore controls price inflation. Economic commentators generally regard interest rates as the “price” of money. It is from this fallacy that the belief arises that manipulating interest rates has a predictable effect on the demand for money in circulation relative to goods, and therefore can be used to target price inflation. This line of reasoning makes even a sieve look watertight. Interest rates are the preserve of the future exchange of goods relative to today and have nothing to do with the quantity of money. They only determine how it is used. In a free market, rising interest rates tell us that demand for credit is increasing relative to demand for cash, while falling interest rates indicate the opposite. What matters are the proportions so allocated, and not the total.
Therefore, if a central bank increases interest rates, it will be less demanded in the form of credit. In the past, before consumer credit became the dominant destination of bank credit over industrial production, increasing interest rates would discourage marginal projects from proceeding, and it would make many projects already underway uneconomic. Raising interest rates, therefore, acted to limit the production of goods and not the demand for them. In the first stages of a central bank induced a rise in interest rates, the limit placed on the supply of goods is even likely to have the effect of pushing prices higher for a brief time or encouraging import substitution, given the stickiness of labor markets because a rise in unemployment is yet to occur.
It should be apparent that management of interest rates before consumer debt came to dominate credit allocation was never going to work as a means of regulating the quantity of money, and therefore price inflation. Nowadays, new credit allocation is less angled at increasing and improving production, and its greater use is to finance mortgages and consumption. This is particularly true in the US and UK, but generally less so elsewhere.
Therefore, the consequences of managing interest rates are different from the past in key respects. Raising interest rates does not, in the main, reduce consumer demand for credit, except on mortgages, which we will come to in a minute. Credit cards and uncollateralized bank overdrafts typically charge as much as 20% on uncleared balances, even at times of zero interest rate policy, demonstrating their lack of interest rate sensitivity. The same is true of student debt.
Interest on motor loans and similar credit purchases are set not by central bank interest rate policy, but by competition for sales of physical product. Manufacturers have two basic sources of profit: the margin on sales, and the profits from their associated finance companies. It matters not to them how the sum of the two add up. If wholesale interest rates rise, squeezing their lending margins, they can subsidize their finance operations by discounting the price of their products. Alternatively, by expanding credit, and assuming they have the capacity to do so without committing additional capital, the marginal cost of that credit expansion is tied to extremely low wholesale deposit rates. This is the benefit to a manufacturer of having a captive bank: expanding credit out of thin air to finance sales is low cost.
