Long-term interest rates are going up, leaving those with too much debt struggling to catch up.
Everyone will be watching the U.S. Federal Reserve over the next few months to see whether or not the cost of borrowing money will increase. Even if Federal Reserve Chair Janet Yellen decides not to postpone an interest rate hike, long-term interest rates will go up in gradual increments over the next few quarters in order to manage inflation.
The U.S. economic outlook is favorable compared to the rest of the world. The United States continues to lead the global economy, accounting for almost one quarter of the world’s gross domestic product (GDP), and the conditions exist for Yellen to start normalizing rates before the end of 2015.
The Federal Reserve, like all central banks, adjusts interest rate risk through the sale or purchase of government bonds, buying these if it wants to achieve a rate drop; increasing liquidity in the banking system and selling them if it wants interest rates to rise.
A rate increase is due and is approaching even if the Fed procrastinates. This is because it is difficult to achieve its stated goal of stimulating the economy while keeping inflation in check. This will result in raising the short-term interest rates that banks use to lend each other money and of course on what they charge the average consumer in need of a loan.
In theory, the increase should be equal to the official rate, but this never happens in practice. The actual interest rate charged to consumers is always higher. It is based on the difference between the nominal rate established by the Fed and the inflation rate; the calculation of which the consumer will not realize immediately because the effects are not immediately clear.
The intention of the Fed is to stimulate the sluggish world economic outlook and reduce inflation. An increase in interest rates, therefore, is becoming more and more plausible. As we are told; unemployment rates are dropping, which is starting to put pressure on inflation.
Nevertheless, the Fed must also contend with the effects of a strong U.S. dollar and U.S. economy. The greenback has been trading at its highest-ever levels compared to the euro and six-year highs compared to the Canadian dollar, setting record highs against the Mexican peso as well.
A higher dollar, in turn, decreases the real rate of inflation probably below the Fed’s two percent target. However, there is a problem with lower prices: demand. At some point, demand exceeds supply, prices rise, and demand drops again. This causes production, employment, and wages to drop as a result. It’s basic economics.
Interest Rate Forecast for 2016 – 2017
The dollar becomes stronger and attracts foreign investors. And here’s the catch: a higher dollar intensifies competition between U.S. companies. Those that fail to respond adequately to the change may be forced to close.
The result is no mystery: unemployment and instability at the national level. This would then lead to a worldwide slowdown due to the U.S.’s continued role as engine of the global economy. Therefore, the Fed will try to seek a balance in the market not only in the U.S.—but worldwide. Janet Yellen has often announced a rate increase, and the statements have not translated into facts thus far. But it will be difficult to avoid this for much longer.
Everything hangs on the value of the dollar. In addition, for all of the U.S.’ continued dominance of the world stage, the stock market crash in China and concerns of a possible major crash in 2016 have shown that the two countries’ economies are tied hand in glove with each other. Thus, future decisions by the Fed are going to have to consider too many factors to the kind of stability markets need.
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Still, a sum of the latest developments and statements suggests that it is only a matter of time before interest rates increase. This would be the first increase after almost ten years, leaving a generation of analysts—about a third—unprepared. Indeed, they are unequipped to deal with the shift, having never seen the frequent interest rate fluctuations of the past.
For many young traders and finance professionals, the very idea of what to do after a rate hike itself will come as a shock. For example, the effects of a rate hike on the international markets are one of the biggest potential pitfalls. There is a risk that emerging markets will react to the increase in interest rates by the Fed with excessive volatility. How would these young traders manage that risk?
Chart courtesy of www.StockCharts.com
According to Christine Lagarde, Director of the International Monetary Fund (IMF), the simple rumors of a Fed rate hike in 2013 fueled speculation and uncertainty in the Asian markets. At that time, driving down the dollar against the currencies of the region. This time, the effect, given the current trend, might be the opposite because of the large amount of liquidity available in the international financial market.
Low Interest Rates Have Generated Their Own Kind of Weakness
There is the danger that after an extended period of comfort, monetary policies will explode in different directions, fueling volatility. Still, the Fed will raise rates before 2015 ends. Opinions as to whether Ms. Yellen will raise rates are split in two camps.
Those advocating, or predicting, the later date are largely optimists who see the markets through rose-colored glasses or computer screens. They are confident that slower growth in China will not jeopardize the United States’ economic performance.
They also see wages rising at a faster rate in 2016 as labor availability is absorbed by the market. On their side are the International Monetary Fund and the World Bank, which fear the hike will have a negative impact on the performance of emerging markets.
Realists will politely point out that inasmuch as the Fed will hear the IMF’s concerns, its duty is to do what is best for the American economy. The Fed will disregard the impact of a rate hike on emerging markets, noting that global financial stability is not within the realm of its responsibilities, leaving the IMF to manage it. Certainly, it would not be the first time that the Fed has ignored the IMF’s advice.
IMF Worried About Higher U.S. Dollar
They would have to pay more for commodity prices (mainly sold in U.S. dollars). Moreover, most of the developing world’s debt is expressed in U.S. dollars, lifting most of their debt. A rise could therefore prompt a period of turbulence. The markets have already gotten a whiff of this from China over the past few weeks. Nevertheless, the latest employment numbers indicated that employment is reaching record high levels.
Chart courtesy of www.StockCharts.com
While the employment report failed to provide clear signals in favor of a rate hike in the fourth quarter, the probability of a rise in September remains high because, compared to the rest of the world, the U.S. is doing very well. Too well, perhaps.
The European Central Bank has lowered its estimates of GDP and inflation and there is the risk that the latter might go up too fast in the U.S. given this comparative scenario. With wages rising and job numbers stabilizing, the Fed’s main job will be to control inflation, especially as oil prices are bound to rise again.
Indeed, not only will rates go up, they may well go up in successive hikes. Small hikes perhaps—no more than a quarter percent for each quarter of 2016—even if it means that China might retaliate by further devaluating the yuan. There is a line, after all, that China cannot cross because it would stimulate excessive capital flight (capital controls are very porous) and run away downward pressure on the yuan.
Finally, the ultimate argument supporting the implementation of a rate hike is that any further delay in implementing a hike might signal panic if investors were to interpret the Fed’s inaction as a sign of concern about the prospects of growth in the United States, as well as China.
The risk is that authorities in China may not see a hike in economic terms, choosing to react politically. Doubtless, there will be some (it’s not a matter of “if”) immediate and negative implications for the country. A rate hike is not welcome in Beijing. And the people’s Bank of China may try to further decouple from U.S. monetary policy, given that at this time China has no room for monetary tightening given the weak economic situation. China could then respond with a further devaluation.
Higher U.S. Interest Rates Could Spark Chinese Economic Collapse
China is reluctant to deregulate and to reduce government manipulation. China would then opt to turn the yuan into an international reserve currency through the SDR mechanism.
Beijing can also retaliate using its holdings of U.S. debt securities. After Japan, no other country holds as many U.S. treasury bonds as China. And it could put them up for a fire sale.
Even if the Fed focuses on U.S. concerns, raising interest rates, as it will, there is still a world to consider.
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The U.S. economy, as strong as it might be, is still integrated in the global economy. And its actions have inevitable boomerang consequences. In such a globalized and economically interdependent world, we should be ready to deal with the fact that a collapse of emerging economies will have negative reverberations on the United States.
The strength of the dollar, after all, is no accident. It has resulted from the heavy capital outflow from investors in emerging economies, leaving their financial systems weak, forcing governments into having to adopt high interest rates to avoid the currency collapse and hyperinflation.
This has the effect of weakening industrial and agricultural investment, generating a stalemate, such that economic crisis leading to financial crisis and back again. More alarming is the possibility of a Greece collapse situation affecting most emerging economies. Indeed, most emerging economies have funded their growth after a long period of credit expansion.
Gold is the Best Hedge Against Economic Collapse in 2016
The low borrowing rates stimulated the rise of the economic and financial sectors as well as private individuals’ debt (in U.S. dollars). Should emerging economies collapse, it will be next to impossible for many of their citizens to honor their huge debt burdens, compounded by the fact that the debts are in dollars. How will these emerging markets repay their debts if their currencies depreciate against the rising dollar (an inevitable effect of rising interest rates)?
In the background are the overly low prices of raw materials, from oil to iron, copper, and other metals needed for the modern economy to function. Therefore, a further strengthening of the dollar reflects the weakness of the global economy.
Therefore, in 2016, given the circumstances mentioned above, there is the risk of a financial and economic collapse much more intense and dramatic than the collapse of Lehman Brothers in 2008. This would cause a collapse of the world monetary system and the collapse of sovereign wealth funds.
Only precious metals like gold and silver would be spared by such grand-scale failure. Indeed, they would see their prices increase, given that physical precious metals are the only asset that central banks and governments cannot control.