Maybe it was Australia’s decision to hike rates last week, the first monetary tightening among the G20 nations since the financial crisis began. Or perhaps it’s just the recognition of economic fate. Whatever the catalyst, Fed chief Ben Bernanke is now talking openly of the “exit strategy.”
“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period,” Bernanke said yesterday, based on prepared remarks published by the Fed. “At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”
The Fed’s exit strategy has been a topical subject on The Capital Spectator since May, when we wrote that “there will come a day when the great countercyclical monetary operations of the Fed should cease and desist.” Such chatter was widely unpopular in the spring, even if the issue at hand was always a question of timing. But a lot has happened since May and apparently it’s now safe to talk in respectable circles about the day when Bernanke and company will begin reversing the Great Easing.
At the moment, however, there’s no imminent sign of higher rates. Based on implied rates in Fed funds futures, the odds of a rate hike look slim until early next year. But the days of cheap money, for good or ill, are numbered.
That doesn’t necessarily spell trouble for the capital markets or the global economy, although the change in the monetary weather that awaits represents a secular shift of considerable magnitude. Consider the chart below, which graphs more than 50 years of monthly 10-year Treasury yields through last month. No one can say with certainty that yields won’t go lower in the foreseeable future, or perhaps even dip into negative territory, as recently occurred in Sweden, when the Riksbank became the first central bank to go negative by dropping one of its key rates below 0% in July. But we’re not holding our breath in anticipation of a repeat performance in the U.S. or Europe.
A more likely outlook at this juncture is that low rates stay low for a time, a view embraced by Bernanke via his reference to keeping monetary policy “accommodative” for an “extended period.” But extensions eventually run out and no one should doubt that the clock is ticking. Short of an extraordinary turn for the worse in the global economy, which looks unlikely at the moment, the case for higher rates starting in the first half of 2010 looks better than even.
To some extent the change, when it comes, will be good news. The Fed will only begin elevating the price of money when it believes the economy can weather the adjustment. But the new game plan will also mark a new era for interest rate trends: up. And this time, the momentum isn’t likely to be temporary.
The implications aren’t necessarily dire, but neither are they irrelevant. Low and falling rates have contributed to rising asset prices and otherwise offered cover for ill-advised financial decisions over the past three decades. Yes, other factors have been instrumental in the bull markets of the past several decades too, but falling yields have been integral to the story. The assistance has come erratically, sometimes fading altogether for a time. Secular trends in the price of money are a bumpy affair.
What’s different now, in looking ahead into medium and long-term horizons, is the likely absence of low and falling rates as a general proposition. True, the markets have known periods of rising rates over the last 30 years, but they were short-lived episodes. Nor do we mean to suggest that the future is sure to bring steadily rising rates, ascending to the old highs of the early 1980s. But markets can no longer count on a broad, extended retreat in the price of money. The shift will change the profile of investing, perhaps only in subtle ways. Nonetheless, it seems likely that the margin for error in owning various types of risk will shrink, if only slightly.
Investing, in other words, will be tougher in the generation ahead vs. the last 30 years. Rising interest rates won’t be the only reason, but the trend promises to be a first among equals.