The US Federal Reserve boosted key short-term interest rates by one-quarter percentage point last week, making the third increase this year. The Fed has done just that so far this year, but not all analysts are certain a ‘stumble’ is imminent for stocks, partially because rates are still at 40-year lows and the Fed’s hikes have been much less wrenching in recent years than they once were. In the early 1980s for instance, Fed policy-makers were known to elevate target interest rates a percentage point at a time. Nowadays, the kinder, gentler Alan Greenspan has been raising rates at a quarter point at a time, and only after a great deal of warning and hand-holding for investors. That might suggest that the Fed’s rate increases would have less of an impact on financial markets than formerly, but that’s not to say that the impact would be sterile.

Typically, higher interest rates are not so great for stocks. A backward outlook demonstrates that equities have returned an average of 21.86 % during low rates, whilst barely 2.84 % through tightening periods. Well, this isn’t rocket science since higher interest rates slow the stream of money through the economy, wounding corporate earnings and rendering stocks less appetizing. This sequentially makes bonds more attractive ventures, whereby stock prices have to drop to compete. Today, this scenario has evolved and the Fed’s boost has been so anemic that the outlook for stocks will depend further on auxiliary factors, including the attitude for oil, hovering just below $ 50 a barrel, and geopolitical uncertainties. Consequently, the outcome might be singular this time and the resulting feature might be small gains for the economy and equities in the impending months.

Alternatively, the behavior of the bond market is insinuating less sanguinity for the macroeconomy. Since the Fed initiated its campaign to boost short-term rates, the rate on longer-term Treasury bonds have actually fallen and sharply. Is this a fluke? The bond market is not as dumb as it may appear. The ‘flattening’ of the gap between short-term and long-term rates is a symptom of a weaker economy on the way. Further short-term rate hikes are only accelerating this process and aggravating the effects of higher oil prices and other economic headwinds.

Moreover, higher rates will be inclined to boost the dollar; fewer dollars flowing through the monetary system will render them more valuable. And overseas investors are more prone to dump Yen and Euros for dollars in order to buy bonds with higher yields. Nevertheless, the dollar fell last week after the Fed’s hike! Is this a sign that the currency market feels the same way as the bond market? Are we in for a bad time for the dollar? Actually, markets could see higher risks of slowing activity from a recurring increase in oil prices and thereby the Fed might safely close the first chapter of the tightening cycle and switch to a ‘wait’ mode. Such a plausible scenario could be negative for the dollar, adjacent to expectations.

The timing and magnitude of repeated intervention looming ahead is therefore liable to generate conflicting outcomes, enclosed with uncertainties. Financial markets are hence unlikely to pursue standard trends or attain targeted levels in the short run.

<B>Nitish Benimadhu

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