Hike Discussion With Wrong Focus

To many economists the current interest rate environment proves to be a mystery. The stock market is propped on inexpensive debt and some of the lowest earnings historically. On the flip side, we are hitting familiar highs with average income, and decent employment numbers. And yet, much of the discussion based around the 25-basis point hike should not be focused on the US—as volatile as it may be.

The issues become more apparent when one consider the interest rate climate in Europe, according to Bill Gross of Janus Capital. With a potentially more attractive US treasury, the current exodus of Japanese and European investors will reach new highs. As investors move out of these bond markets, the relevant prices will drop significantly. Consequently, this creates a bond market bubble of sorts, as investors pile into the “high-yield” assets. Clearly, this potentially inflates the value of the US treasuries to a point where any hike has made negligible differences on absolute returns and therefore a net-neutral effect on lender mentality.

The issue with a net-neutral effect is that any movement of interest rates after the initial hike will have drastic effects on the market. Europe would face a deeply discounted and vastly illiquid bond market where the creation of new debt would understandably be difficult.

During the 2008 recession, this sort of credit crunch is what hit banks and lenders the hardest. A lack of credit is certainly a scary reality, but with the negative interest rate environment, the question rises about how likely such a scenario might be. So while American investors seem so preoccupied with domestic developments, the real issue might originate from overseas.

FT

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