By Professor Ricardo Ulivi, Ph.D.
October 2014
A few months ago the Fed announced that they were likely to end the latest round of their quantitative easing (QE) program in October, which means they will stop buying bonds on a massive scale. The reason? They believe the economy is improving, and therefore there is no longer any need for this extra stimulus. However, they have indicated they will continue to keep short term rates at zero for the foreseeable future.
We all know that the Fed has kept long and short term interest rates artificially low, and that has been one of the key reasons for growth in the economy. Nevertheless, economic growth has been much slower than the historic norm.
The stock market has been taking advantage of these record low interest rates and has reached all-time highs. However, the moment of truth may have finally arrived. What will happen to stock prices now, given that interest rates may no longer be manipulated? Let’s review some possible scenarios.
Scenario 1: The economy continues to be weak
If the economy continues to be weak, we can expect interest rates to remain low, especially since inflation continues to be minimal. Why is inflation so low? There are many reasons, including the fact that commodity prices have plunged, along with oil prices, and China continues to sell us volumes of goods at unreasonably low prices.
However, if interest rates remain low because the economy continues to grow slowly, why are stock prices at record highs? In this scenario, I would expect stock prices to drop, because they cannot persist at these levels given that the economy, under this scenario, continues to grow at a weak rate.
Scenario 2: The economy picks up
With oil prices down, inflation super low, and employment growth continuing, you would expect the economy to grow at a faster rate than it is currently. What would that do to interest rates? It might push them up to a more reasonable level. For example, the ten year AAA bond rate might move closer to 4% over the next twelve months. In this case, what would happen to stock prices? I predict they would drop.
Scenario 3: The economy declines and we go into recession again.
I would give very little support to this scenario, so I will not analyze. It seems most unlikely that we will fall into recession again, unless something bizarre happens that we did not expect at all, like a major bankruptcy in China or an unfortunate war breaking out somewhere in the world.
Conclusion
October is the last month the Fed will buy bonds through their QE program. How will this affect interest rates? To a great extent, the answer depends on the performance of the economy during the next few months. If it keeps getting stronger, you can expect interest rates to rise. If growth continues to be below average, rates should continue to remain low, especially because inflation is under 2%, and that does not justify today’s stock prices.
The last few days have seen increased volatility in the stock market. Is this a sign of things to come? Maybe the moment of truth has arrived.
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