Effect of Rising Interest Rates on World Financial Markets, Currencies and Gold

Interest-Rates / Financial Markets Jun 19, 2007 - 02:37 PM

By: Christopher_Laird

In this article, we discuss what rising interest rates will do to world financial markets, currencies, commodities, and gold.

Leveraged markets do not like rising interest rates

With rising interest rates, financial markets are in the beginning of a major trend change. I like to call it a major sea change. For the last 5 years (further back actually considering Japan) world interest rates have been way below historical averages. During this time, unprecedented leverage has found its way into asset and financial markets such as stocks.

Historical average interest rates run about 6%, going centuries back.

When interest rates are abnormally low for extended periods of time, asset and financial markets end up in big bubbles. Eventually, when everyone who wants to borrow money is maxed out, and invested in everything they can, the bubbles collapse. For this reason, it is my strong suspicion that our unprecedented world asset and financial bubbles will be harmed severely by a new sea change of rising interest rates that is beginning.

Now, world interest rates have already been rising for about a year, and the US had already raised from 1% to the present 5+ % range. The EU and China are also raising now for a time.

Japan started this whole liquidity binge in the mid 1990s after their stock and real estate bubbles collapsed around 1990. That led to the infamous Yen carry trade exploding. In the ensuing years, from ‘95 to the present, the Yen carry trade grew and grew, and now amounts to much more than $1 trillion value of hot money that is leveraged into financial and world asset bubbles presently.

But, after 911 and the resultant US interest rate of 1%, the US joined the bottom interest rate club. So, during the last 5 years, another huge wave of cheap money found its way into financial and asset markets like real estate.

Not surprisingly, the commodity complex and gold benefited from the various outcomes of low interest rates and emerging financial and asset bubbles. Real estate construction in the US and world wide, particularly in China, and housing booms everywhere, caused price spikes in commodities. Gold naturally benefited greatly, and rose from the $250 bottom range to the present $650 range, roughly a 250% gain. The gold and resource stocks also benefited greatly, and until just recently, became the hot new sectors for investors everywhere. Now, these complexes are either correcting a bit, or are flat.

But, the real story is one of rising interest rates, and the resultant threat of unwinding in all markets that the super cheap borrowed money found its way into.

My observation is that not near enough attention is being given to the effect that rising interest rates would have on all markets, naturally causing some unwinding of leverage.

The world is the well into the greatest across the board asset and financial bubble in history. A primary reason for these asset and financial bubbles is the cheap credit regimes that have been with us since around 1995 (Japan) and the rest of the world for the last 5 years.

Now, another very important point is to consider that we are not merely observing a 1% or so rise in world interest rates in the last year. (Japan excepted). The important issue is that we are just now emerging into a trend change to a rising interest rate environment , and what that would portend for highly leveraged markets.

The logic follows then, that if asset and financial markets react to rising interest rates, they will naturally start unwinding, and if rising interest rates stay with us, will unwind with increasing magnitude.

Commodities

If this is true, then the commodity complex would also find unwinding pressures. As financial markets decline over time, and economic demand slows, physical demand for commodities will also start to decline. The amount of that decline depends on how much world consumers actually pull back. At that point, we must consider the effect of deleveraging in the commodity complex, as speculators have wagered heavily in commodities up to now. I have stated before that commodities are way over their historical norms, and are likely to revert to lower levels again if there is a serious economic slowdown. This is particularly true if one considers all the leverage speculators have infused into the present commodity prices. Much of the increases in commodity prices can be tracked to the world liquidity boom, and the demand caused by this, driven primarily by ultra low interest rates for the last 5 years.

There are arguments being put out that China will continue to grow at over 10% a year, and that eventually the Chinese (and other Asian) consumers will replace the Western/US consumers, and offset the drop in demand overall. This view is premature, however in my opinion.

Considering that the US consumer is said to account for a massive 29% of world GDP, and that the Chinese economy is roughly ¼ the size of the US, it seems implausible that they will be able to replace a drooping US consumer at this stage. There is also the fact that the Chinese consumer presently accounts for a decreasing percentage of Chinese GDP, not an increasing percentage. And now, with the Chinese stock markets exploding in an incredible manner, the prospect of those markets eventually crashing, and taking the savings of much of the Chinese middle class, would not be helpful to the theory that an emerging Chinese consumer will replace the US consumer if there are stock crashes…

Currencies

In the last few years, the Yen and the USD had been in falling trends, no doubt hurried along with the ultra low interest rates in past years. But now, with a US rate in the 5+% range, and looking to go higher, the USD is strengthening. Eventually the Yen may also begin strengthening. Japan also may find itself having to raise their interest rates a bit too.

The trouble is, with rising interest rates and rising currencies, like the Euro, the USD and possibly the Yen at some point, there is immense pressure on financial bubbles.

I would think the biggest threat is the Yen carry trade starting to unwind, and consequent strengthening of the Yen. In late February, this year, Asian market crashes led to further Yen carry unwinding, as people liquidated positions and bought Yen, and also caused strengthening of the Yen. The Yen rose 6% in that two week episode, an astounding increase in that amount of time. That resulted in further pressure on the Yen carry trade to unwind, as speculators were looking at huge losses from a rising Yen alone, since they had so much borrowed Yen out and invested in markets.

As far as the USD is concerned, it has been rising modestly. Rising US bond yields, now in the range of 5.14% (Ten year) cause people to park more money in the USD. That leads to a rising USD. That movement causes some unwinding of financial markets, as people sell some stocks, or whatever, and park money in ‘safe' US treasuries for 5.14% or so.

This kind of trend, moving money out of stocks to bonds is highly exacerbated by rising interest rates. As interest rates rise, people sell stocks and buy bonds. Stocks fall and then, if people expect interest rates to continue a rising trend, people then sell more stocks seeking to lock in gains from the previous stock bubbles. The net result is a vicious cycle of stock sales to cash out and park money in bonds, then further stock declines.

In short, rising interest rates are a major problem for stock bubbles. This is particularly true if there are big stock gains, as we have all over most of the world. People tend to park money in safety when there are big gains.

Now, people may think that, to stem this vicious cycle, all the central banks have to do is reduce interest rates again. The trouble with that scenario is that stock collapses happen in a very short time, and by the time central banks react, people have lost so much money that investor and consumer sentiment is permanently harmed. Thus, the typical refrain that Central banks can drop interest rates to stop crashes and economic decline does not pan out ultimately. But it is a nice sounding argument to perma bulls.

Gold

Gold right now appears to be trying to decide if rising interest rates are yet at the point of popping the world stock bubbles. As I said, if these do pop, then the commodity complex would be hit by a combination of speculative unwinding and deleveraging, and also by dropping consumer demand. Gold naturally is associated with dropping commodity prices.

In addition to this, if world markets start to unwind in a big way, like happened late February this year, gold ends up being sold to cover margins and such. This is particularly so, now, because of the incredible amount of leverage outstanding in financial markets.

However, unlike your usual commodity, gold is money. Ultimately, that aspect reasserts itself, and gold does well. In deflationary times, what is king? Money! That fact proved to be true in the Great Depression of the 1930s when gold and gold stocks did quite well, after the initial stock crashes world wide. This is also true if world central banks end up having to inflate massively to try and stem dropping world economic demand after stock crashes.

By Christopher Laird
PrudentSquirrel.com

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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