The first month of 2017 came and ended without much-flurried activities in the global stock markets. There was no Capricorn Effect, no Lunar New Year jinx; neither was there any continuation of the Donald Trump-rally nor were there massive buying of stocks in anticipation of a better global economy after the US posted better-than-expected economic data.
There was no continued appreciation of the US dollar on higher expectations of further rate hikes, but there were explicit signs that global stock markets have been holding very well. Too well, in fact, which suggests excessive optimism when there are clear and present threats that could possibly send investors scurrying for cover – Brexit! Rate hikes! Increased geopolitical tensions!
The charts, despite continued optimism displayed by investors, are starting to blink amber in the short-term. But who would argue against a correction after such a good run since November last year when the Dow Jones Industrial Average (DJIA) surged from below 18,000 points to almost 20,000 points in January?
Not to be outdone, perennial underachiever Straits Times Index also jumped from a low of 2,760 in November to an intraday high of 3,027 on 16 January before succumbing to correction. Not too bad, but the chances of a correction are even higher considering that the economy of Singapore is not expected to improve in 2017 while local investors will soon face the possible wrath of more selloff when companies announce their earnings.
The Beginning Of US Rate Hikes?
This seems like a no-brainer, and investors ranging from students studying economics 101 to retirees living on their nest eggs are expecting the US Federal Reserve to continue increasing Fed fund rates this year. Why would the Fed raise rates? What are the conditions that feed the fertile ground for rate increases?
Strong US labour market is one factor, check! At 4.7 percent, US unemployment rate is trending at its lowest in decades.
Inflation rate at 2.1 percent in December 2016, which is the Fed target rate, will trigger more hikes, so check!
Once a strong labour market gets tighter, workers earn more and that will in turn push prices higher, so check again!
Unless unforeseen events unfold within the next few months, we can expect financial markets to get jittery over talks of rate hikes in the forthcoming months. But rates hikes means inflation which also means that prices get higher and companies earn more, right? That is a good thing; a sign that the economy is improving and stocks markets trend higher, right?
A Good Thing?
The beginning of a rate hike cycle typically signals an expanding economy, and stock markets tend to rally even higher after knee-jerk corrections immediately after the announcement of the rate hike. Such a pattern will repeat itself again and again, with the magnitude of the corrections dependent on the quantum of the rate hike and/or the accompanying statements post-hike decision.
Hence, we should expect the stock markets to trend higher and higher with corrections along the way. While this is the short-term fluctuation of post-hike stock markets but, once interest rate reaches a level deemed as “unacceptable” by market participants such as when interest rates rose rapidly from 1998 to 1999 (see Figure 1), the stock markets will correct itself such as when the DJIA plunged from 11,500 in 1999 to a low of 7,500 in 2002.
Another point to take note is that when US 10-year Treasury yields drop, it would mean that interest rates are either low or are falling hence the DJIA rose – a very clear cut case as shown in Figure 1 since 1995. The ultra-low interest rate environment since 2010, which was further helped by more rate cuts, sparked off an unprecedented Bull Run in the US stock market that has lasted till today.
Therefore we can conclude that an increase in interest rates signifies an expansionary economy, which is good for the stock market until interest rate rises to a level that is deemed too high or unsustainable. But what is too high or unsustainable is determined by the market, and not decided by a set of hard and fast rules that govern the free market.
Some people can argue that interest rates are still too low but the situation now is different from back then.
To combat inflation, the Fed funds rate reached a high of 20 percent in 1979-1980 but let us not forget that globalisation was not predominant back then and asset prices were much lower while debt levels were also much less of a concern compared to modern times when tens of billions are just some figures on government books.
On the other hand, interest rates have just climbed away from its lowest-ever level. Hence, how much higher interest rates will go (and how much farther) will depend largely on the strength of the global economy. Suppose the US GDP grows at a rate of 3.5 percent every year for the next three years, how much would the Fed need to hike in order to tame inflation? Conversely, the Fed may not need to raise interest rates if the US economy starts to stall after finding the recent hike too hot to handle.