It looks like the shockingly bad first quarter of growth for the US economy was a fluke after all.
The second quarter saw US growth bounce back rapidly, with the economy growing at an annualised rate of 4%. And the 2.9% decline reported in the first quarter was revised down to a 2.1% slide.
Of course, good news on the economy raises the one question that markets fear the most.
When will the Federal Reserve start raising interest rates?
One way or another, US rates will have to rise
The Fed has cut right back on quantitative easing (QE – money printing) this year. The US central bank is now pumping ‘just’ $25bn a month into the US bond market. It expects to stop altogether in October.
But that’s just the beginning of the tightening process. We’ve grown so used to the current environment that it might even seem normal to some. Yet back in 2009, all of this zero-rate stuff was meant to be about emergency measures. Can you really justify 0% interest rates at a time when GDP growth is this high?
Current Fed boss Janet Yellen seems to think so. She acknowledges that the economy is improving. But she also says that low rates are needed to keep unemployment falling.
Now, as I’ve noted before, unemployment is a ‘lagging’ indicator. In other words, the economy gets better, then unemployment falls. This is why it’s odd that Yellen keeps emphasising employment.
Central banks are traditionally meant to act ahead of time. If they don’t get rate rises in early, then inflation has the chance to pick up, and they find themselves playing catch-up.
But as David Bowers of Absolute Strategy Research notes in the FT today, there’s a good reason for Yellen to stay ‘behind the curve’. Governments across the globe are now so indebted that they “look to monetary policy to help debase the debt. They now need central banks to adopt ‘debtor-friendly’ monetary regimes committed to robust nominal GDP growth and tolerant of higher wage growth.”
So, while central banks might officially target 2% inflation or so, the ‘real’ target could be more like 3-4%.
Yet regardless of what Yellen does, it’s hard to see how she can keep rates low for very much longer. We’ve already seen the first Fed rebellion.
At the meeting just past, Charles Plosser of the Philadelphia Fed objected to the Fed stating that it would keep rates low “for a considerable time after the asset purchase programme (ie, QE) ends.” He wanted it to at least consider raising rates sooner.
If the economy continues to recover, then the rest of the decision makers at the Fed could shift over to Plosser’s side. Or inflation will start picking up, to the point where the market effectively forces interest rates up.
What this means for US assets
This environment will eventually prove toxic for bonds. Bonds pay a fixed income. So if interest rates or inflation or both go up, bond prices will drop.
Here’s an example. Right now, if someone you trusted to pay you back offered you £5 a year interest in return for a £100 loan, that’d sound pretty good. A 5% low-risk return is good at a time when you’re lucky to get 2% from the bank.
But if you could get 7% from the bank, that deal wouldn’t look so good. You might consider lending £60 for £5 a year (which even then is just an 8.3% return), but you wouldn’t go to £100.
In short, a fixed income becomes less valuable as interest rates and inflation rise.
What do you invest in instead? Well, it’s not necessarily ideal for US stocks either. A bit of inflation is usually a good thing for stocks. Companies are able to raise prices and maintain profit growth as long as inflation doesn’t go wild.
But US stocks are very overpriced by historic standards at the moment. At least some of this overvaluation has been driven by QE. With QE coming to an end, companies will have to work harder to justify their valuations. At current prices, that looks a tall order.
However, one asset should benefit – the US dollar. Rising rates usually spell a stronger currency.
And there are a number of ways to profit from a stronger US dollar. One is to buy FTSE 100-listed companies who report profits in sterling, but make most of their money in dollars. If the dollar strengthens against the pound, these companies get a boost from the shifting exchange rate. Plenty of big blue-chips fall into this category, from the oil majors to the miners to the big pharma stocks.
If you’re a currency trader – and remember that currency trading is high-risk stuff and not for the uninitiated – one of the most vulnerable currencies right now looks to be the New Zealand dollar. So, shorting the Kiwi versus the US dollar (with a stop loss above the recent all-time high) looks a potentially good trade.
There’s another – less high risk – way to profit. Buy Japan. All else being equal, a stronger dollar and a weaker yen are good news for the Japanese market. Japan is also further behind the Fed in terms of QE. In Japan, there’s still the potential for more QE – and even if it’s not forthcoming, the Bank of Japan has already done a lot more money printing compared to GDP than the Fed ever did.
You can read more on promising Japan funds in this recent MoneyWeek magazine piece by David Stevenson. If you’re not already a subscriber, sign up for a free trial, and you can read the article and subscribe to MoneyWeek magazine.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.
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