June 12, 2013
It's starting to sink in. Investors worldwide have been selling stocks and fretting about bonds as they digest the possibility that an era of tremendous stimulus and unnaturally low interest rates could be ebbing.
Since mid-May, investors have been preoccupied with watching the Federal Reserve for warning signs that the Fed might stop trying to stimulate the economy by keeping rates artificially low. But this week, interest rate watchers were troubled by more than the Fed's possible next move. Analysts are debating whether the bond market has taken on a mind of its own, with interest rates possibly rising whether the Fed actually drives them or not.
In reaction, investors worldwide dumped bonds and stocks Tuesday, and the Dow Jones industrial average closed down 116.57 points, at 15,122. Earlier, the Dow had declined 150 points.
Analysts are warning that the fear of rising rates is likely to cause stock gyrations this summer.
The prospect of higher interest rates is unsettling because investors know that higher loan rates can discourage businesses from making large purchases or dissuade potential homebuyers from taking on mortgages. Stocks can decline if investors expect business profits to be limited. Bonds and bond funds suffer losses when interest rates climb.
Normally, stock investors are not alarmed in the early stages of rising rates because rates generally are driven up by prosperity. But there is nothing normal about the current environment. The Federal Reserve and other central banks around the world have been trying to stimulate growth since the 2008 recession, but after all the effort, the global economy remains lackluster. The weakness presents the risk that higher rates could stifle growth when there is little to stifle in the first place.
Part of the nervousness in the market was set off Tuesday when Japan did not add to the stimulus it has been using this year to bring the country out of its long slump. Some analysts interpreted Japan's action as a sign that central banks worldwide aren't inclined to continue the massive stimulus of the last couple of years, even though economic weaknesses remain.
Interest rates climbed globally on government bonds everywhere from Spain to Brazil. Emerging market stocks and bonds were particularly vulnerable. In Thailand and the Philippines, stocks declined almost 5 percent. European stocks dropped about 1.3 percent.
Moody's economist John Lonski noted the unique nature of the recent spurt in interest rates and pinpointed what's caused nervousness among investors: "The (U.S.) 10-year Treasury yield has soared from an early May low of 1.63 percent to a recent 2.21 percent without a visible assist from commensurate improvements in the outlooks for both the world and U.S. economies," he said.
Because a stronger economy is absent, but rates are soaring anyway, "the latest climb by borrowing costs is likely to slow expenditures going forward," Lonski said.
Higher rates might "cause companies to shift back into consolidation mode and delay the long-awaited growth acceleration again," said Steven Ricchiuto, Mizuho Securities economist.
Until recently there has been optimism in the stock market. Analysts had predicted that by the second half of the year the impact of higher payroll taxes and U.S. government spending cuts from sequestration would wear off, and growth would be strong.
Now, Lonski points out that the opposite might occur. "To the degree second-half business sales disappoint, private sector interest rates will be even costlier relative to benchmark Treasury yields, and business spending on both equipment and staff will be jeopardized."
The Dow has climbed 15.4 percent this year.
Some analysts think most of the damage from rising rates may have already happened. If, indeed, rising rates end up stifling growth, investors will likely be fearful about the economy and corporate profits and might seek safety in U.S. Treasury bonds rather than stocks. That would make yields dip again and mitigate the losses that have been occurring.
Also, high interest rates attract investors. Jim McDonald, chief investment strategist for Northern Trust, says he expects the popularity of U.S. Treasury bonds to keep interest rates from rising much further. When bonds are popular with investors, yields decline, because investors don't need to be induced to buy them.
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