How an Interest Rate Hike Could Provoke a Destructive Tsunami

Published by Philippe Herlin | Oct 13, 2016 | Articles

The possibility of a hike in long-term rates is becoming a recurrent issue of concern in the markets. Will the Fed raise its rates? Are investors anticipating a normalisation in the yield curve? More important is the question of all the liquidity created by the central banks since 2008.

Their gigantic printing schemes, known as “Quantitative easing”, have pushed the OECD’s central banks’ balance sheets from the equivalent of 10% of the GDP to 35% of it today, or nearly 13 trillion dollars created out of thin air... But only a small fraction of all that money went into helping the real economy, through a small increase in credit. The remainder found its way in fuelling the real estate market (in the United States, Japan and England since 2013) and propping up the stock market – especially the sovereign bond market. This is the reason why the long-term rates have come down so much, to the point of being negative in several European countries.

It is easy to understand how the fear of a rate hike, whether real or imagined, spells disaster for those holding those bonds that yield nearly nothing or even cost them, because their value will plummet. (As a reminder: those bonds are issued at a fixed rate, so a 100-euro bond yielding 1 euro a year will see its value cut in half if newly issued bonds yield 2 euro a year. Its value will then be 50 euro in order for it to have a yield of 2%, like the newly issued bonds, all thing being equal.)

This hike, real or not, will provoke a tsunami of selling and money will try to find new supports, which will create some bubbles and also, since the enormous amounts in play, inflation. Given, as we said, that the real estate and stock markets are already at a peak, we can predict this fresh money will rather go toward commodities (oil, notably), which will mechanically push consumer prices up. And then a price/interest rate spiral will start, and it will be impossible to keep rates from rising. Afterwards, we will have to deal with the aftermath of derivatives – which are, in essence, products based on interest rates...

All this money created out of thin air by the central bankers – which, up to now, was lazily going into sovereign bonds – might be unleashed on the markets and in the economy, bringing its lot of upheaval in terms of prices shooting up and banks defaulting.

Thus we understand how panicky central banks are at the prospect of a brutal hike in long-term rates and why they are so prudent when talking about it. They would still rather increase their money printing than run this risk... although it will only make things worse and kick the can down the road a little further.

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Philippe Herlin  Finance Researcher / Member of the Editorial Team


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