Get Ready for Higher Interest Rates

by Anthony Mirhaydari | March 4, 2011 3:41 pm

For months, I’ve been warning of the risks of inflation and higher interest rates and how money is about to get more expensive. For more, be sure to check out my Jan. 19 column, “Our next economic worry: Inflation[1].”

Now, with the situation in North Africa and the Middle East, the media is focusing attention on fast rising food and fuel price inflation. There are signs that these pressures are feeding into so-called “core” measures of inflation, and central banks are preparing to take action. The European Central Bank looks ready to move first. And it could move as soon as next month according to Capital Economics chief European economist Jonathan Loynes.

A plethora of emerging market economies including China, Brazil, and Indonesia have been on the rate hike campaign for awhile. But this makes the beginning of the tightening cycle for the major developed economies. And as the world’s main sources of capital, that has far reaching implications for the global economy, the housing market, the financial markets, and consumer confidence.

The call to action comes in the wake of the ECB’s interest rate decision this morning. The Europeans are on high alert after inflation jumped to 2.3% in the eurozone in January, up from 2.2% in December and above the ECB’s target of near but just below 2%.

While rates weren’t changed, that wasn’t the big takeaway. Modern central banking is all about the expectations game. And ECB president Jean-Claude Trichet did everything he could to prep the markets for a rate hike by saying that “strong vigilance is warranted … to contain upside risks to price stability.”

Loynes notes that similar phrases were used as “very clear indicators of imminent rate hikes in previous tightening cycles.” That cycle started in December 2005, and the “strong vigilance” language signaled an interest rate rise was just one month away. Also, the ECB removed comments that current rates were “appropriate.”

So what does this all mean for American investors?

inflation interest rates chart

The first reaction was in the foreign exchange markets where the dollar is plunging against the euro as investors price in higher interest rates and a more stringent anti-inflation policy stance out of Europe. In fact, the greenback has fallen through 3 years of trend line support today. This will bolstering the strength of foreign stocks vs. U.S. equities, push commodity prices higher, and add to America’s own inflation pressures by pushing up import and energy prices.

That last point is key — with the problem of higher import prices feeding into higher U.S. inflation and eventually forcing the fed to start its own tightening cycle. Despite all of this, Fed chairman Ben Bernanke wishfully told Congress that he believed big increases in the price of food and fuel wouldn’t have more than a “temporary and modest” impact on consumers. The evidence, and the actions of his contemporaries in Europe, suggests otherwise — and that means we are moving closer to a 1970s-like scenario of stagflation.

The Fed will come under intense pressure to pull back its monetary policy support. As the tide of ultra-cheap money finally goes out, it will reveal many structural problems that have until now been masked by the flow of liquidity. Housing will be impacted. The fiscal situation at the federal, state, and local levels will be impacted as financing costs rise. The financial sector will be pinched by higher funding costs. The list goes on.

And as this plays out, consumer confidence will be shot to hell first by rising prices and then by higher credit costs.

inflation and interest rates chartAs a result, I’ve recommended that my newsletter subscribers lighten up on their U.S. equities while increasing their exposure to foreign markets. For those looking for overall exposure, the Vanguard Emerging Markets (NYSE: VWO[2]) is worth a look. For individual country plays, the Global X Colombia (NYSE: GXG[3]), iShares China (NYSE: FXI[4]), and the iShares Chile (NYSE: ECH[5]) all look attractive. And for individual stock picks, my favorite right now is Bancolombia SA (NYSE: CIB[6]).

Disclosure: Anthony has recommended CIB to his newsletter subscribers.

Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to Investorplace readers. The author can be contacted at[7]. Feel free to comment below.

  1. Our next economic worry: Inflation:
  2. VWO:
  3. GXG:
  4. FXI:
  5. ECH:
  6. CIB:

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