Get ready for higher interest rates

The wait is over. After years of ultra-cheap money, short term interest rates are set to rise as central banks bring the fight to inflation. That's damaging the dollar and sending investors back into emerging market stocks.

By Anthony Mirhaydari Mar 3, 2011 4:42PM

For months, I've been warning of the risks of inflation and higher interest rates and how money is about to get more expensive. Be sure to check out my Jan. 19 column, "Our next economic worry: Inflation."

 

Now, with the situation in North Africa and the Middle East focusing attention on fast rising food and fuel prices, and signs that these pressures are feeding into so-called "core" measures of inflation, 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?

 

 

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 worsen as financing costs rise. The financial sector will be pinched by higher funding costs. And as this plays out, consumer confidence will be shot to hell first by rising prices and then by higher credit costs.

 

As a result, I've recommended that my newsletter subscribers lighten up on their U.S. equities while increasing their exposure to foreign markets as they start to outperform American stocks in a big way for the first time in months. For those looking for overall exposure, the Vanguard Emerging Markets (VWO) is worth a look. For individual country plays, the Global X Colombia (GXG), iShares China (FXI), and the iShares Chile (ECH) all look attractive. And for individual stock picks, my favorite right now is Bancolombia SA (CIB).

 

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 MSN Money readers. Click the link above to sign up.

 

The author can be contacted at anthony@edgeletter.com. Feel free to comment below.

4Comments
Mar 3, 2011 10:38PM
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Surprised Well, it's about time.  Hopefully, the world banks can appropriately reduce the monetary candy before we get an inflation rush.  It would be a great achievement if all the world economies could function in an orderly fashion without major crisis.  Hopefully everyone learned there's no free lunches and even the banking leaders and politicians can become corrupted and greedy. Those that saved and have been paid nothing for the last three years deserve more.

 

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It's not candy either for many of us, but bitter poison.  How do you think seniors, disabled and unemployed people living off their savings are doing at 1%?
Mar 4, 2011 8:57AM
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Rates should have been raised months ago. The easy monetary policy is what got us here then continued to slam those of us retired. We need less manipulation from the likes of Bernanke and the Government. The taxpayers who paid for the sins of the greedy are still not bailed out.
Mar 4, 2011 10:36AM
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Keep up with the " Voice of Doom " crap, eventually you 'll have to be right
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