Interest rates in the United States, interconnectivity of markets and little pinches of salt

28 January 2015

Speculation for speculations sake?
As we move through the first few months of 2015 economists remain focused on the economy of the United States and what the expected level of interest rates in the world’s largest economy will mean for the rest of the world and the long awaited economic recovery.

The level of speculation is so great that for the first time since the turn of the century the US dollar has risen in value against all of the major currencies in the world (broadly defined as the pound, the euro and the yen). In real terms both the Euro and the Yen have fallen 12% in value against the dollar in recent months.A greater demand for the dollar by investors in reality reflects an expectation that interest rates will rise from their current level of 0-0.25%. Therefore investors are looking to cash in on a return that is expected to beat what is currently offered on the pound, the euro, and the yen (also close to zero).

Add into this equation the fact that Japan and Europe (with the exception of the UK) are pursuing a policy of quantitative easing (explained below) making it more likely that interest rates in Europe and Japan will remain close to zero makes the United States look like a more than attractive bet.

When will interest rates rise in the United States and by how much?
Not surprisingly there is no consensus on when interest rates will rise in the United States. Some commentators expect a rise in the middle of the year while other like Bloomberg expect no rise before November 2015.
When rates rise they are likely to do so in incremental creeps of a quarter percent. Therefore it will take some time before they recover to healthier levels for savers of around 5%.

Does the economy of the United States matter as much as it used to?
To a certain extent the United States isn’t in a position to act as the world’s economic engine driving the economies of the world forward anymore (as it managed to do in the late 1990’s). In economic terms the recession ended in the United States in the middle of 2009. Despite this the country has struggled to breach 3% annual growth rates.
This doesn’t mean that the United States is no longer important or indeed relevant to the world’s economic recovery.
All economists remain focused on the United States and in particular what will happen to the level of interest rates in what is still the world’s largest economy.
In other words what happens to interest rates in the United States will have implications for the rest of the world.

Why Europe and Japan Also Matter – Who’s up for some quantitative easing?

The policies of Europe and Japan will have a significant impact on the economy of the United States and possibly on interest rates policies too.
The European Central Bank (ECB) this week launched a program to purchase more than one trillion in bonds essentially by printing Euros (and therefore increasing the money supply).Japan has adopted a similar tactic and has begun injecting 700 billion annually into its economy (and will continue injecting additional funds until inflation reaches it stated target of 2%).

These policies represent a significant relaxation of monetary controls and will act as a stimulus on economic activity in Europe and Japan.
Beyond this if you increase the supply of a currency then you reduce its value against other currencies. In other words the Euro and the Yen – all things being equal – will fall in value against the US dollar. A stronger dollar could slow growth and inflation in the US and make it less likely that the Federal Reserve will increase short term interest rates.

The implications of a stronger dollar

A stronger dollar is likely to have three effects on the domestic economy in the United States:
  • A stronger dollar will act to dampen down inflation. This would be viewed as undesirable by the Federal Reserve who have targeted a rate of 2% for price inflation (it should be noted that price inflation has remained below this target for the last 31 consecutive months).
  • A stronger dollar will hurt US exporters as their products become in comparative terms more expensive. At the same time it will make imports into the US cheaper.
  • A stronger dollar will make US financial assets more attractive possiblyleading to an inflow of investment funds. This could cause the necessary impetus to “heat-up” financial markets.

Will the effect of falling US exports really be that significant given lower oil prices?

The short answer to this question is possibly not. Exports account for only 13% of US economic output, and even tough a strong dollar makes US exports less competitive the economic impact of a stronger dollar may be outweighed by the benefit of falling oil prices the effect of which should be to significantly reduce the cost of production.

A pinch of salt

To a certain extent everything I have written is no more than academic speculation that can, if you so desire, be taken with a pinch of salt.
In the final analysis prediction of interest rate movements – and market movements in general – is a lottery because we are living in unique times.
Take a look at this recipe and try and guess what will emerge from the oven.
Take the stagnant economies in Europe and Japan and the slowing economy of China, add in a dash of very low inflation (in most cases below the rates their respective governments have targeted), mix in a hefty dollop of quantitative easing, fold in  falling world oil prices, and bake in the centre of a hot oven.
Who knows what will come out?

The end of a long cold winter?

As I have written in the last paragraph forecasting is at best a lottery.
This aside it does seem that by a massive coincidence of economic factors the world might just be in a position where it is able to emerge from the long cold seven year winter it has suffered since the financial collapse of 2008. The key to unlocking a full blown recovery may be the combined effect of lower oil prices and quantitative easing stimulating a recovery in Europe and Japan. The knock on effects of such a recovery for the world are obvious.
So the question on everyone’s lips is.
Will 2015 be the year when financial markets finally begin to recover?

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