Times have changed and today we live in a global economy. An inter-connected world where goods and capital move freely at lightning speed across countries. The widely accepted view is that globalization not only benefits all countries across the world but lends itself towards the betterment of the economy as a whole.
As we have seen, globalization can also have a negative impact with a domino effect in times of turmoil and unrest. This impact affects the financial markets both in the US and abroad.
Flight to Safety
When there is political unrest, which sparked recently in Egypt and has continued to spread like wildfire throughout the Middle East, global investors get nervous and shed their risky assets like Stocks and flee to the safe haven of the US Dollar and US Bond market.
This geopolitical unrest can often create a buying binge, which helps Bond prices improve. However, there are growing concerns that, in the financial markets, trump the disturbing news coming from the Middle East, which will be a guide force for interest rates in the times ahead. What might that trump card be?
Inflation, Inflation, Inflation
Inflation is the arch enemy of Bonds, even if it is across the pond. The increase in global unrest, not just in Egypt but in other parts of the world as well, is mostly attributed to economic factors – primarily runaway inflation in commodities and food.
The People’s Bank of China has raised interest rates a couple of times, most recently by 0.25% in an effort to head off a continued rise in consumer prices in China. The culprits? Soaring food prices and higher raw material cost lead the pack.
China has also tightened lending standards by requiring Banks to raise their capital reserve requirements. In their latest reporting, China’s inflation rose by 4.9% year over year. This was lower than their expectation however still marked their highest reading in a couple of years. China may have to tighten their belt some more.
Brazil is appearing on the scene with the hottest rates of inflation in six years. They are attributing this to a rise in food costs and increased bus fares. Yep, bus fares! It is anticipated the central bank will raise the benchmark interest rate for a second straight time in March in an effort to contain the spike in inflation.
The British are grappling with inflation as well. Their year over year reading struck a hot nerve with 4% which is twice the rate of the Central Bank’s target. The UK has yet to address this with rate hikes because their economy is in such bad shape that any hike would make matters worse.
Inflation is beginning to become a problem in Europe where it has risen to 2.4%. This is super hot and well above the European Central Bank’s (ECB) comfort zone of beneath 2%.
With an inflation problem in Europe, the ECB will eventually have to raise interest rates to fight it. When they do, the Euro will strengthen against the dollar, making European Bonds more attractive than US Bonds. This attraction will likely put a damper on US Bond purchases, causing interest rates to rise.
Many of these countries within Europe have a high number of union workers. They could very well demand pay increases to offset the higher cost of living, the result of this inflation. Which would exacerbate matters. Could this be a recipe for more protests and unrest?
As we see signs of inflation around the world, the US isn’t immune. With the second round of quantitative easing, known as QE2, (here’s a refresher on QE2) The Federal Reserve’s stated goal is to boost Stock prices, create inflation and lower the unemployment rate. These are all unfriendly to Bonds and will cause interest rates to move higher. As the old trading saying goes…“Don’t Fight the Fed” - it’s a bit like the Golden Rule … “he with the Gold, rules.” If the Fed wants to accomplish these goals at the expense of Bonds, they probably will.
Some good news…
Despite inflation rising around the world, the global economy will continue to recover and growth will continue to expand even it if feels a bit like your teenager learning to drive a stick shift…uphill, with plenty of stops and starts. It’s not so smooth, and often a bit unnerving. And it will require a touch of patience. Here at home, consumer confidence has picked up and touched the highest level since February 2008. With continued confidence as the economy picks up speed, housing may begin to show signs of improvement as well.
These are unprecedented and very interesting times. Historically speaking, interest rates are still extremely attractive and remain close to the historic lows. As I mentioned in a recent Post as a percentage of total income, the cost of owning a home is less expensive that it’s been at any time since 1963. so ifyou, or someone you know has been thinking about purchasing or refinancing…this is the time to get started!