The End Of Zero Interest Rates May Create A 'Huge Financial Disruption Akin To The End Of A War' - CREDIT SUISSE

By Ashley Kindergan: It wasn’t so long ago that the challenge of making money with interest rates stuck around zero was investors’ top concern. Those days are gone. Today, they’re worried about the opposite: the threat that now-rising rates pose for fixed income investments. That, and the downturn in emerging markets that many only recently embraced in the hunt for yield caused by those near-zero rates.
It’s easy to identify the date that things changed: May 22, the day that the Federal Reserve first alerted markets that it might soon start “tapering” the $85 billion in monthly asset purchases it has been making since December to juice the economy. And soon looks to be getting even sooner. A steady improvement in U.S. employment figures—unemployment fell from 7.6 percent in June to 7.4 percent in July—has brought into focus the 6.5 percent unemployment target the Fed set as a prerequisite for raising short-term interest rates. On Thursday, the U.S. Bureau of Labor Statistics released yet another piece of good news on the employment front: New applications for unemployment benefits sank to their lowest levels in six years in July.
That’s great news for Americans who happen to be landing new jobs, but not as pleasant for bond investors worried about rising rates.
The employment data, as well as news that inflation rose significantly in July (another potential trigger for the Fed to tighten monetary policy) led investors to dump U.S. Treasuries Thursday, pushing yields to a two-year high. The yield on a 10-year Treasury bond has topped 2.8 percent, about 60 percent higher than at the beginning of the year.
Now that yields have started climbing, investors should expect that improving economic momentum will keep them moving higher – and that will have serious implications for investors in the world’s three largest economies: European Union, Japan and the United States. “In our view, the potential end of near-zero interest rates is exactly the type of event that can trigger enormous changes in asset prices and capital flows within and across economies,” Credit Suisse’s fixed income strategy team explained in a note this week called ”Zero Isn’t Forever.” “This can create a huge financial disruption akin to the end of a war.”
This particular “war” is ending later than it should have, the team wrote, arguing that long-term interest rates have remained low far longer than the data warranted. Rates in the G3 started falling in mid-2011, when the European crisis was at its worst. But industrial production momentum, a key indicator of global economic activity, started looking more solid as early as last November. Add to that the steady recovery in the U.S. labor market and the receding threat of a breakup of the euro zone since European Central Bank President Mario Draghi’s July 2012 pledge to take any measures necessary to hold the monetary union together, and one would have thought rates would have been climbing some six months before the Fed caused such pandemonium in May. So why didn’t they? Because the major central banks continued easing in the face of that good news, that’s why. And why would they do that? Because they were more focused on falling inflation, despite the fact that inflation is a lagging indicator. (If it’s not one thing, it’s another.) The recent jump in long-term rates, then, is simply an overdue correction. “We think long-term interest rates were significantly mispriced even before tapering talk began,” the strategists wrote.
The uptick in industrial production momentum around the world, which tends to track quite closely with long-term bond yields, is still going strong, and the analysts expect it to continue putting upward pressure on rates. Global industrial production momentum went from -1 percent in November to 4.1 percent in May, and the strategists expect it to hit 7 percent by the end of this year, as both Europe’s painful recession and China’s significant slowdown appear to be flattening out.
The good news: rising rates may not necessarily prove to be the economic headwind some investors fear. For one thing, short-term rates are still low in the developed world and are expected to stay that way for some time. The Federal Reserve isn’t expected to raise the federal funds rate until mid-2015. While consumer and business confidence has been so downtrodden since the financial crisis that ultra-low rates haven’t done as much to encourage borrowing as they might have, the Credit Suisse strategists think that’s also about to change. “When confidence improves while real interest rates are unchanged, conditions ease,” they wrote. “Tightening of financial conditions could easily be overpowered by a reawakening of dormant animal spirits because…policy effectiveness is increasing as confidence returns.” In other words, the more that people feel better about where the economy is going, the more that monetary easing will have the effect that it’s supposed to have.
That doesn’t mean nobody will feel any pain. In still-struggling economies, including peripheral European countries such as Spain and Greece, rising rates could easily put an end to fragile recoveries that have been showing up lately in the form of improving manufacturing activity and confidence. Credit Suisse strategists believe that central banks in such places might just implement more stimulus to counter the headwind effect of rising rates. “The ECB’s long list of policy options is a powerful warning to investors who might doubt the staying power of the recent recovery on the basis of a potential further increase in yields,” they wrote.
Rising rates leaves fixed income investors with difficult decisions, the strategists noted. On the one hand, flourishing global industrial production is usually good news for both commodities and emerging markets that are the source of those commodities, the manufacturing centers for goods exported to the developed world, or both. Rising rates, on the other hand, are bad news for emerging market bonds, into which investors were pouring money earlier this year in search of higher returns. With Treasury yields on the rise, so too will the number of fixed income investors who decide to forego the higher credit and liquidity risks of emerging market investments in favor of developed world paper. (The same, incidentally, is true of higher-risk junk bonds. Investors pulled $388.2 million from high-yield funds last week.) Developed markets are becoming more attractive for another reason, too—their industrial production momentum has been catching up to that of emerging markets. In fact, the gap between the two is the smallest it has been since the 1980s. In a turn of events that few predicted, the global economy’s growth engine is shifting from the fast-growing but much smaller emerging markets to the larger, developed-world economies, and investors have acted accordingly. “Crisis risks have swung hard away from the North Atlantic,” the Credit Suisse strategists wrote. The long nightmare of the western world’s economies, in other words, is coming to an end. It’s someone else’s turn to ruin investors’ dreams.

The Financialist is a digital magazine presented by Credit Suisse that looks at the trends and ideas that drive markets, businesses and economies.

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