How an Interest Rate Rise Could Trigger a ‘Punch Bowl’ Rally.
We hate to do it.
As much as we try.
But he’s impossible to ignore.
That’s right, we’re talking about US Federal Reserve Chairman, Dr. Ben S. Bernanke.
He’s just finished giving testimony to the US Congress. Asked about the impact of low interest rates, the Fed Chairman said the Fed was ready to take ‘away the punch bowl’.
In other words, raise interest rates.
That’s bad news for stock markets, right? Maybe not. In fact, if history is anything to go by, it could result in the best bull-run the market has seen in nearly 10 years…
Our view on the global economy and markets is that it’s stuffed.
But, that’s not new. The global economy and markets have been stuffed for years. The trick is to recognise that so you can protect your wealth when things go pear-shaped, but also to take advantage of wild market moves — whether that’s up or down.
And that means paying close attention to what’s happening in global markets…
The immediate reaction is to think that will be bad news for stocks. After all, with all the debt in the economy, higher interest rates means higher interest costs.
But is that necessarily true? Certainly there’s an element of truth to it. But nothing is ever as simple as it seems. One consequence of higher interest rates is that investors will be more prepared to save and lend…because they’re getting a better return for their money.
That should make it easier for firms to borrow money. And so what if they’re paying a higher interest rate, at least they can borrow funds to grow their business.
And if we look at the effect of rising interest rates on stock markets, if the last time the Fed took ‘away the punch bowl’, maybe the impact won’t be as bad as most think.
Here’s a chart of the US Federal Funds Rate from 2002 to 2012:
After dropping interest rates to 1% in 2003, the US Fed kept rates low before raising them from 2004 through to 2006. By the time the Fed stopped raising rates, the Fed Fund rate was at 5.25%.
But what about the stock market?
Here’s the interesting part. Check out this chart:
The red line is the Aussie ASX/S&P 200 index. The blue line is the U.S. S&P 500 index.
The first green bar covers the time when US interest rates were at 1%. The purple line shows the period when the Fed raised rates from 1% to 5.25%. And the second red line covers the period when rates were at the peak.
From bottom to top, the US market gained 80%. It gained 35% during the period of 1% interest rates and then added another 40% as rates climbed.
Where is the US market now?
Over a period when the Fed has kept interest rates lower for a much longer period, the US market is up 75%. So if — and it’s a big if — the US economy does stabilise and the Fed indicates rate rises are on the way (not likely before 2014), it could be the cue for the market to head higher.
And the prospects for the Australian share market could be even better. Notice that from 2003 the US market took off much faster than the Aussie market.
So that while today the US market is less than 10% below its 2007 peak, the Aussie market is still 40% below the 2007 peak. It has a whole bunch of catching up to do.
But if the global economy recovers, it should mean more demand for Aussie resources. We don’t mean it will be a return to the China-led resources boom, but if investors are more realistic about the potential returns from resources stocks, you should see stocks rise from their current beaten-down level.
As we say, we’re still sceptical about the chances of a global economic recovery. But you shouldn’t discount the possibility.
Things are playing out eerily similar to the last time the Fed fiddled around with interest rates. If the Fed does eventually ‘take away the punch bowl’, stock markets (including the Aussie market) could see the biggest bull-rally in more than 10 years.
This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.