The consequences of the Feds rate hike..

April 17, 2015 10:51 AM

Although sometimes we doubt whether the Federal Reserve is going to increase interest rates soon, it is worth analyzing the consequences of such a game-changing move.

The hike would be the first in nearly a decade. Theoretical effects of rising interest rates are well-known: higher interest rates mean higher borrowing costs (something to consider: if you have a variable rate mortgage and believe that Fed will eventually hike interest rates, think about locking in at current low rates with a fixed-rate mortgage), lower asset prices, reduced risk-premium and a stronger greenback.

All of these are relatively bad for the stock market. Higher discount rates mean lower stock prices, while reduced risk-premium makes equities less attractive compared to new issues of bonds.

Higher borrowing costs hurt indebted companies, while a stronger greenback negatively affects the exporters and international businesses, which are a significant part of the U.S. stock market. This is why the equity indices were generally falling in March in anticipation of the Fed’s hike and surged after the publication of the dovish Federal Open Market Committee statement.

There are sound arguments for the Fed’s hike being priced in stock market and U.S. dollar indices. This is how markets generally work: investors buy the rumor and sell the actual event. In a sense, the Fed may be forced to hike interest rates since the February report has already caused the rise in market interest rates and decline in stocks prices.

It means that global investors are not waiting for the Fed to raise interest rates and are already betting that interest rates are going to increase in the U.S. this year. Indeed, according to Chicago Mercantile Exchange Fed Watch (on March 19), the Fed's funds futures contracts suggest a 12 percent probability of a June rate hike, a 49 percent probability of an increase in September, a 70 percent probability of a rate hike in October, and an 79 percent of December rate hike.

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About the Author

Arkadiusz Sieroń is a certified Investment Adviser. He is a long-time precious metals market enthusiast, currently a Ph.D. candidate, dissertation on the redistributive effects of monetary inflation (Cantillon effects). Arkadiusz is a free market advocate who believes in the power of peaceful and voluntary cooperation of people. He is an economist and board member at the Polish Mises Institute think tank. He is also a Laureate of the 6th International Vernon Smith Prize.