HAVE WE REACHED THE BOTTOM OF INTEREST RATE CYCLE? END OF QUANTITATIVE EASING IN THE US AND ITS REPERCUSSIONS – BY Dr. BOBBY SRINIVASAN AND Dr. SUDHAKAR BALACHANDRAN

July 28, 2014 | Posted by bobbysrinivasan << back to blog

Janet Ellen, US Fed Chairman, recently made a statement that the Fed’s asset purchase is set to conclude in October 2014. What does that mean? The consensus expectation, which includes Federal Reserve members, is that the rate will begin to rise, sometime in 2015. Does that mean that a low interest regime will come to an end soon? We need to revert back to history.

Since the US exited the recession in 2009, the Federal Reserve has been forced to maintain its zero rate interest rate policy (ZIRP) to boost the economy. Why exit now? The Federal Reserve may be thinking that this low interest rate is either fuelling asset bubbles or the economy is mended completely and is on its way to full recovery.

The questions then are:

How high the interest rate may climb in 2015?
What will happen to the US currency value in relation to other currencies?

First, let us address the hike in interest rate. In order for the interest rate to move up, we need the economy to move out of the current sluggishness. So, we can expect the rate to be minimal. Right now, the US economy is heavily burdened with debt which exceeds 100% of GDP. So, if interest rates were to soar back to normal levels, the interest payments on the debt would account to nearly a third of their government annual budget. Look at it this way. The first quarter GDP in the US suffered a negative 2.9%. Of course, the weather is partly to blame. Even if adjusted for good weather, the growth rate is likely to be ordinary and vulnerable to external shocks. The Fed has recently adjusted the growth rate projections from 3% to 2.3% for the year, which, probably, is still high.

The long run interest target will at best be 4% to 5%. This is the most optimistic estimate possible from the investors in treasury notes and bank certificate of deposit’s point of view. The Fed will take small and cautious steps only since the fear of pushing the economy back to slow growth as a real possibility. The investor need not rush into the debt market as the change will be gradual. For them, the choice is obvious namely, stay with the high yielding stocks.

Now, let us turn our attention to the value of a dollar against its major trading partners. Japanese Yen, with their economy in major recession, is unlikely to pick up in value against the dollar. Some of the Eurozone countries are facing real deflation and so, the hike in interest rates is next to impossibility. Dollar will gain significant strength against the euro. China will, of course, fight all pressures and try to keep their currency at a value where their export market is not affected in any way.

Finally, the deflationary pressure on the global economies is somewhat real. Any skirmish in the Middle-east if it expands from the current levels, could drive the global economy into a recession. Whichever way we look increase in the interest rates in the US in the future is a remote possibility. In this environment, investing in gold is not wise as there is more downside risk at this stage.

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