When Will Yellen Launch Higher U.S. Interest Rates?

interest ratesAt the height of the Cold War, the biggest concern was the global destruction associated with launching nuclear weapons. Fast-forward 50 years and not much has changed. At the height of the money-printing war, the biggest concern is the global destruction associated with launching higher U.S. interest rates.

Time Is Ticking on Low Interest Rates

Under the helm of Ben Bernanke, the Federal Reserve initiated its first round of quantitative easing (QE) in November 2008. The Fed used its unprecedented bond-buying program to artificially lower long-term interest rates in an effort to support the housing market, create jobs, and essentially kick-start the economy.

It’s debatable just how much good three rounds of QE did for the U.S. economy. What everyone can agree on, however, is that ultra-low, barely there interest rates made it easy to borrow.

For retail investors, the cheap dollar made the stock market look increasingly attractive. With interest rates at zero, where else are you going to invest your money? Since the markets bottomed in March 2009, the S&P 500 has soared more than 215%, while the Dow Jones Industrial Average has climbed a healthy 180%. However, according to the CAPE ratio (a cyclically adjusted price-to-earnings evaluation tool), the S&P 500 is overvalued by 68%. The last times the markets were this overvalued were in 1929 and 1999.

What did three rounds of QE and low interest rates do for the U.S. economy? Well, it certainly helped propel the stock market higher. But other than that, not much was affected. Low interest rates decimated retirement portfolios. Unemployment numbers fell while underemployment has remained above 11% since September 2008. And most of the jobs being created now are part-time and come from low-paying sectors like retail and restaurant services. Moreover, personal debt levels remain high, wages are stagnant, and the wealth gap continues to expand.

Outside of the U.S., lower interest rates also made it easy for emerging and developing countries to borrow money. According to the International Monetary Fund (IMF), there is a strong correlation between gross inflows to emerging markets (since 2009) and the size of the Federal Reserve’s balance sheet.

Between 2011 and 2013, for every billion dollars of QE, flows to major emerging economies like the BRIC nations rose by about $1.4 billion. During this time frame, the Federal Reserve’s balance sheet jumped from $2.4 trillion to $4.0 trillion. Cheap money might be good when your economy is charging ahead but when it’s lackluster, it’s going to be tough to pay it back, especially when interest rates rise.

The Return of the 2013 Taper Tantrum?

The big question remains: when exactly will new Fed Chair, Janet Yellen, start to raise interest rates? And how will the markets respond? If history is any indicator, it won’t be pretty.

On May 22, 2013, the Federal Reserve announced that it would begin tapering its generous $70.0-billion-a-month monetary policy, otherwise known as quantitative easing. News that Wall Street’s favorite “sugar daddy” would be reining in its monthly allowance sent the markets reeling.

It also prompted investors to flee the risk of emerging markets. The emerging economies that were an important driver of global growth were seen as having their capital inflows pulled out from under them.

Eventually the markets rebounded, soaring higher after the Fed announced that the end of QE didn’t mean interest rates would automatically climb higher. In fact, the Fed said it wouldn’t start to raise interest rates until it felt the U.S. economy was on stable ground.

News that cheap money would continue to be available to those who can afford it made the markets happy. But cheap money cannot last forever. Janet Yellen needs to raise interest rates but she also wants to avoid the May 2013 “taper tantrum” that befell her predecessor, Ben Bernanke.

While many thought interest rates would rise as early as this June, recent economic data suggests they may not rise until later this year. The U.S. Department of Labor announced that hiring slowed sharply in March. On top of that, consumer spending, capital investment, and manufacturing have all slumped.

The global economy is also doing poorly. Emerging economies that once relied on cheap money will have to rely on sources of domestic growth. That’s the only way they will be able to withstand the threat of a higher U.S. dollar. They will also need to see if they can avoid the economic challenges already impacting Brazil and China. Borrowing is risky. An increase in interest rates could cripple businesses addicted to cheap money.

Investors and emerging economies will be holding their breath the next time the Fed meets in mid-June. If Yellen decides that the U.S. economy is still underperforming, she will hold off raising interest rates to Wall Street’s cheering.

That makes September’s meeting that much more foreboding. And it could make this year’s “September effect” all that more volatile, as well as interesting. Even an increase in interest rates of just 0.5% this September could shock an overvalued stock market and unprepared emerging economies.