When Federal Reserve Chairman Ben Bernanke hinted last month that the Fed could soon begin curtailing the $85 billion in bond purchases it makes monthly to support the economy, financial markets dove over the possibility of rising interest rates.
Only subsequent reassurances from members of the Fed's Open Market Committee averted a potential collapse. Bernanke said on Thursday that the Fed would continue to be "highly accommodative" in aiding the economy, and the market forged highs.
These events show the power of the bond-buying strategy, known as quantitative easing, on investors. In buying bonds, the Fed has pumped money into the economy and kept interest rates artificially low.
But the guessing game on what the Fed's next move might be has created such a volatile market that even the biggest bulls would want a safe haven.
Some investors have rushed to cash, which, in a recession, is king. But will a rise in interest rates be reflected in an increase in the rates banks pay on deposits?
Rising interest rates impact directly on fixed-income securities, including bonds.
The higher the cost of money, the greater the investment return required to justify the risk of holding non-cash assets. Further, the cost of money raises the margin rate required for borrowing against securities. This reduces demand for equities -- notably Treasury bonds, where 100 percent margin is permitted.
Precious metals are affected by any increase in the cost of money.
Real estate prices are affected by mortgage rates, which largely are based on the yield of the 10-year Treasury bond. As a long-term asset, real estate is less sensitive to short-term rate fluctuations.
Under normal conditions, the Fed tightens rates to curb inflation. Higher rates make fixed-income securities less attractive, and money tends to rotate out of bonds and into equities, which act as a hedge against inflation.
However, financial conditions are far from normal. The Fed has subsidized bond markets massively. By pushing interest rates below positive "real" returns, bond, equity and real estate markets become highly risky.
Where should investors put capital to preserve it? Investors have moved out of bonds, bypassing equities and heading for cash. Should interest rates rise, cash may earn a real return. Loaded with cash and low demand for credit-worthy loans, it is unlikely that banks will raise deposit rates soon.
Evidence is mounting of spreading global recession. U.S. economic growth, "officially" rising at 1.4 percent assuming an inflation rate of 1.5 percent, is suspect. If the 6.5 percent inflation rate calculated by Shadow Government Statistics is used, the United States is in a recession of some -3.5 percent.
In recession, asset prices fall. Cash becomes king.
If central banks continue to dump Treasurys, increased interest rates may be forced upon the Fed, engendering panic. Investors would be wise then to switch to cash or precious metals. Key will be the timing of any reduction in QE.
John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Trib Total Media.
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