From Ankara to Washington, central banks are hiking rates -- and investors are spooked. What lies ahead?
For many market observers, June 8 seemed to be World Tightening Day. The European Central Bank raised its benchmark interest rate by 25 basis points, to 2.75%, as expected. But in a surprise move, South Korea's central bank hiked its key interest 25 basis points, too, to 4.25%. Central banks in Denmark, India, South Africa, and Turkey raised rates as well.
The moves by inflation-wary central bankers have put world equity markets on the defensive, as investors seek the safety of less-risky vehicles (see BusinessWeek.com, 6/8/06, "Stocks Recover Amid Bargain Hunting"). With further monetary tightening expected, investors may have to face continued volatility in the months ahead, analysts say.
TWO EXCEPTIONS. Stock markets worldwide took the June 8 rate-hike spree hard. Asian markets got the ball rolling downward, with both Japan's Nikkei and Korea's Kospi indexes falling more than 3%. European bourses also suffered, as major indexes in Britain, Germany, and France each shed more than 2.5%.
In the U.S., the Dow Jones industrial average recovered from triple-digit intraday losses to finish up 0.07%. The broader Standard & Poor's 500 squeaked higher by 0.14%, and the tech-heavy Nasdaq composite dropped 0.3%.
Two other central banks stood pat on June 8, but they might be the exceptions that prove the rule. The Reserve Bank of New Zealand, which held its rate at a lofty 7.25%, cited a worse-than-expected outlook for inflation. While the Bank of England left British interest rates at 4.5% for the 10th straight month, it's less likely to do so next time, analysts say.
"What we're seeing is a global full-court press on inflation control," says Alan Gayle, senior investment strategist at Trusco Capital Management (STI ).
THE PARTY'S OVER. Against this backdrop, U.S. central bankers have stepped up their own tough talk on inflation, likely paving the way for the 17th consecutive interest-rate hike. On June 5, Federal Reserve Chairman Ben Bernanke said the recent uptick in a closely watched inflation measure was "unwelcome" (see BusinessWeek.com, 6/6/06, "The Chill in Bernanke's Words"). In afternoon trading June 8, futures markets reportedly assessed a 76% chance that the Fed will raise rates 25 basis points at its next meeting, to be held June 28-29.
In recent years, an environment of low interest rates and easy liquidity has emboldened investors to place riskier bets, boosting volatile asset classes like commodities and emerging markets. But as rates increase, market players fear that liquidity will dry up, analysts say. "The central banks are taking the punch bowl away," explains Jack Ablin, chief investment officer at Harris Private Bank (BMO ).
Even deflation-wary Japan has gotten in on the tightening act. In March, the Bank of Japan officially ended its so-called quantitative easing policy, which injected excess reserves into the nation's banking system (see BusinessWeek.com, 5/12/06, "Easing Out of Quantitative Easing").
PRICING RISK. Japan's accommodating monetary policy allowed for "carry trade," a strategy where hedge funds and other investors would borrow cheap yen and use it to buy assets around the world. "The jitters in the marketplace actually started at the end of February, when you started to hear the Japanese talk about the ending of quantitative easing," says Quincy Krosby, chief investment strategist at The Hartford (HIG ).
Of course, tighter monetary policy isn't the sole factor behind the recent stock-market downturn. In a June 8 press conference broadcast via the Web, European Central Bank president Jean-Claude Trichet said ongoing market volatility reflects a renewed appreciation of investment risks.
"There was a certain level of underpricing of risks in the global financial market," Trichet said, observing that other central bankers share this view. "If this pricing of risk goes a little bit up, it would be perhaps going in a direction of better pricing of risks."
BAD COMBO. Risk aversion has helped drive stocks downward as investors move to less-volatile issues, analysts say. "It's not a pricing reassessment," Harris' Ablin says. "It's a risk rebalance." Indeed, riskier asset classes have tended to see bigger declines (see BusinessWeek.com, 6/8/06, "No May Flowers for Investors").
Also on June 8, short-term Treasury yields rose above their long-term counterparts for the first time since March. An inverted yield curve, as this phenomenon is known, has traditionally been viewed as a signal of an upcoming recession. The Treasury market seems to be worried that Fed tightening "plus the combination of the weakness we see in housing and consumer sentiment is going to cause weakness in the economy this year and next year," says Brian Gendreau, investment strategist at ING Investment Management (ING ).
Of course, the markets could be wrong. One factor that could forestall a potential extended downturn is a strong second-quarter earnings season, analysts say. S&P analysts project that second-quarter earnings will increase 8% from the same period a year earlier, ending 16 consecutive quarters of double-digit percentage gains (see BusinessWeek.com, 5/5/06, "Second-Quarter Preview").
OIL WATCH. "I don't think we're at the end of the bull run," says Jean-Michel Six, chief European economist at S&P. "Earnings growth might not be as strong as it was in 2005, but it's still going to be decent. The corporate sector's health is certainly a mitigating factor."
A sustained decline in energy prices could also potentially support equities, analysts say. On June 8, July West Texas Intermediate crude oil futures closed down 47 cents at $70.35 a barrel, after falling as low as $69.10 after the death of Abu Musab al-Zarqawi, the al-Qaeda leader in Iraq.
"The issues in Iraq and Iran will be there and probably put a floor under crude oil prices, but to have oil trade back under $70 would be a helpful development for stocks," says Michael Wallace, global market strategist at Action Economics.
Some say investor sentiment has to worsen before the market bottoms out. "One thing that would be really helpful to get this out of the way would be if sentiment were to get really bad," says Linda Duessel, equity market strategist at Federated Investors (FII ). "Without poor sentiment, it's hard to think that we have a sustainable low."
BOLSTERING CRED. Meanwhile, Duessel and others argue that the inflation threat -- ostensibly the reason central banks are hiking rates -- may be overblown. Fed economists actually lowered their inflation forecast at the May 10 meeting, points out David Rosenberg, North American economist at Merrill Lynch (MER ).
"The Fed is barking about inflation, but it is noticeably absent in their forward-looking models," Rosenberg wrote in a June 7 research report. "This is 100% about bolstering a perceived loss of credibility" (see BusinessWeek.com, 6/7/06, "No More Hints and Whispers").
Until the interest-rate saga plays out, investors will continue to wrestle with uncertainty, analysts say. And that's one thing markets like even less than higher interest rates.