The world is boiling with regional military conflicts in Eastern Ukraine, Iraq, Syria, and Gaza to name just a few. Any of these could escalate into a much wider affair, drawing in greater involvement from the U.S. and its Western allies. The Ebola epidemic has claimed more than 1,000 lives and is threatening to spread to Lagos, Nigeria – the largest city in Africa with a population of 20 million people. Terrorists around the world seem to be gaining in economic and military power, and defense hawks are warning of increasing risks on our soil if aggressive action is not taken to turn the tide.
Broadly speaking, stock market investors seem generally unconcerned about the rising level of geopolitical tensions. Stock prices may sway violently back and forth as the political winds shift, but so far little lasting damage has been done to global equity markets as a result of all this turmoil.
What seems to have the market’s attention is the endless speculation about the Federal Open Market Committee’s (FOMC) strategy for “normalizing” monetary policy. Over the course of 2014, the FOMC has gradually reduced its level of bond buying from $85 billion to its current rate of $25 billion per month, on its way to zero in the fourth quarter. Despite all the angst when this policy was first announced, investors have become comfortable with this strategy. And to the surprise of most observers, interest rates have actually fallen this year.
As we have noted, slowing the purchase of bonds is not actually tightening monetary policy; it is simply reducing the level of stimulus being generated by the Fed. Sometime in 2015, the Fed will likely end the zero interest rate policy that has been in place for the last five years, and actually begin to tighten policy by raising short-term interest rates. With the U.S. economy appearing to be on more solid footing, the Fed wants to avoid a possible overheating that would lead to much higher interest rates and inflationary pressures down the road.
Recent action in the stock market indicates a high level of nervousness among investors about the timing and magnitude of the tightening cycle. Indeed, markets have rallied after weaker economic data is released, and sold off when the data is better than expected. This “bad is good” phenomenon signals that investors want a stronger economy (because it leads to higher profits and healthier corporate balance sheets) as long as it is not too good. In fact, much of the geopolitical turmoil we are now experiencing may be partially influencing the Fed’s tightening plans. Keeping the world’s financial system greased with easy money is one way to keep asset prices rising and economic tensions in check, at least for now.
Stock markets have generally performed well during the last three tightening cycles initiated by the Fed in the last 25 years. However, none began after such a long period of near-zero interest rates and after the Fed spent $3 trillion buying bonds and mortgages to force long-term interest rates down. Whether investors are right to be nervous about the onset of higher short-term rates remains to be seen, and will likely be one of the most important factors driving financial markets in coming months.
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