“So the language that we used in the statement is ‘considerable period.’ So you know, this is the kind of term; it’s hard to define. But, you know, it probably means something to the order of around six months, that type of thing.”
To translate this fragment into plain English: Short-term interest rates, which have been lingering at around zero for years, will go up six months after quantitative easing (QE) officially ends.
If the Fed tapers another $10 billion at each meeting this year, rates will go up at the beginning of 2015 and should be around 1 percent at the end of next year, according to other Fed officials.
Why is this bad news? Because it takes away two stimuli at the same time. The first one is QE. While tapering is something the market is overall comfortable with, its negative impact is most likely underestimated.
Since gains in productivity are still slow, economic growth depends on money creation. Usually, this is done through the banking system, but banks have been disinclined to lend wholesale for some time. So the Fed had to step in to directly inject money into the system.
It didn’t do much for real economic growth, but it at least kept GDP stable and propelled the stock market to all-time highs, an important source of confidence. The buying of mortgage-backed securities also stabilized the real estate sector.
If this marginal demand for risk assets is taken away, things will quickly shift into reverse: Expect lower stocks, lower house prices, a higher dollar—meaning fewer exports—and more stress in emerging markets. None of these factors are conducive for GDP growth and employment.
However, the major factor impacting markets today was the indication that short-term rates might begin to rise at the beginning of 2015. Here is why rising rates are bad news for all capital markets.
First, the short-term rate is not something the Fed sets by pushing a button. No, it’s called “open market” operation for a reason. Through repurchase agreements, the Fed sucks short-term liquidity out of the market and exchanges it with longer-term government bonds.
Because there is less short-term liquidity, rates go up. This is bad news for speculators and banks that have used the current environment to borrow short and lend long. Because the Fed guaranteed low rates for an “extended” time horizon, there was no risk. Simply take out a loan at near zero and invest it in Chinese bonds for two years and pocket the difference.
This certainty of low rates has been taken away as of today, so traders will have to factor in interest rate risk into their models and adjust their positions accordingly. As for the adjustment, one thing is certain: it won’t lead to more buying of risk assets.