An era of cheap money - gone

Rates around the world are heading higher, which could mean the beginning of the end of an era of supercheap capital.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- This month's rise in global interest rates is probably a sign of the beginning of the end of an era of supercheap money - a change with profound implications for the recent record-setting stock rally, the buyout boom and economic growth worldwide.

The question now is how much more rates might rise in the United States and elsewhere, and how that will affect world markets - and hundreds of millions of investors and consumers from Tokyo to Frankfurt to New York.

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The yield on the 10-year Treasury note, which affects rates throughout the economy, has spiked to the highest level in five years on growing worries about rising rates worldwide.
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For years, the world has enjoyed historically low interest rates. This has helped fuel a boom in corporate mergers and private equity buyouts and a rally in stock prices and in other assets, such as real estate. But with economic growth outside the United States picking up and fanning inflation, central bankers around the world are pushing rates higher in a bid to cool growth and avoid bigger problems later on.

"There's been too much global liquidity and now we are seeing a shift away from multi-decades of declining rates and declining inflation," said Josh Stiles, managing director of research firm IDEAglobal in New York.

"This is the end of the cheap money cycle," Marc Pado, U.S. market strategist at Cantor Fitzgerald in New York, said.

The European Central Bank, which sets rates for most of Europe, hiked rates to a six-year high last week. The Bank of England and Bank of Canada are both expected to raise rates next month, and the Bank of Japan is expected to hike rates by the fall.

Higher rates raise the cost of borrowing for businesses and consumers and are poised to impact everything from economic growth and corporate profits to the performance of stocks and bonds and the payments that home owners make.

Here's a brief look at what higher rates will mean for global economy, financial markets and investors around the world.

Bonds

There has been no market where concerns about inflation and rising interesting rates have played out more dramatically than in the usually staid bond market.

The yield on the benchmark 10-year Treasury note hit 5.3 percent this week, the highest level in five years. Yields have backed off a bit since then, but are still up from just 4.5 percent three months ago. The drop in bond prices - and rise in yields, which move in the opposite direction - has come as bond traders unwind bets that rates would stay low - or even head lower still.

"People are being more optimistic about the U.S. economy, and therefore have written off rate cuts from the Fed that they were expecting," said Laurent Fransolet, head of European fixed income research at Barclays Capital in London, referring to the Federal Reserve.

After having been so low for so long, investors are waking up to the reality that yields will rise to more "normal" levels. Long-term Treasury yields have been kept low in recent years, in large part due to strong buying from foreign central banks. But as those overseas investors diversify their holdings, their appetite for U.S. government debt is expected to drop, analysts say. That in itself could feed more bond market selling and more upward pressure on rates.

Bond yields aren't just rising in the United States. The yield on a global basket of government bonds is at 4 percent - the highest level since December 2000, according to the Lehman Brothers Aggregate Global Treasury index, which tracks the performance of government bonds from 33 countries.

Those heavily invested in bonds may be lamenting the heavy selling, but the rise in yields may be something investors have to get used to, said Ken Mayland, president of ClearView Economics, a firm specializing in economic research. "Demand for capital has become much more intense. The improvement in the world economy justifies paying a higher yield - that's not a bad thing," he said.

Higher yields also make bonds a more attractive investment, and if yields keep climbing, as many market watchers expect them to do over the next few years, that could lure some investors away from stocks.

Stocks

Global stock markets have rallied, supported by the buyout boom and a flood of funds from investors large and small alike. But rate concerns pummeled stocks over the past two weeks, until the markets snapped back Wednesday and showed further signs of life Thursday.

Before the recent pull back, the Dow industrials and broader S&P 500 had risen to record highs. Stocks in Europe were rallying too. The pan-European Dow Jones Stoxx 600 is close to its record high.

Why all the turmoil in stock markets? Rising rates dampen economic growth, and that can hurt corporate profits - and stock prices. They also are likely to crimp merger and buyout activity, which has been a key source of support for stocks worldwide.

"Valuations are a function of interest rates," says Christopher Zook, chairman and chief investment officer at CAZ Investments in Houston. "As interest rates move higher, valuations will come down," he said.

Investors are starting to reassess their willingness to take on risk, but rates will have to move much higher before they really start to hurt the stock market, analysts said. The recent selloff took the Dow industrials and the S&P 500 down about 3 percent apiece - a modest decline given the market's recent run. Still, it's not clear the selling is wrung out of the market yet.

Peter Dixon, strategist at Commerzbank in London, expects markets to level off as investors reassess where they see opportunity.

"The warning shots fired by the market will perhaps make investors stop and think about whether they can continue to pile into asset classes without abandon and not have to pay the price at some time," he said.

It will take some time for this to play out in the market, and some markets may be hit harder than others. Dixon thinks European stocks will sell off less than in the United States, mostly because recovering consumer demand should offer support.

Economic growth

Rising rates could hurt economic growth, especially in the United States, where rising mortgage rates could threaten the already fragile housing sector by increasing the burden on home buyers.

The housing sector already faces pressure from an oversupply of homes on the market and falling home values in some markets. The sector also faces risks from ongoing problems in so-called subprime loans to borrowers with weak credit.

Weakness in the housing sector has worried economists, and the market still may worsen. At their last meeting in May, Federal Reserve officials said the downturn in housing was turning out to be more severe than expected.

But even though central banks abroad are raising rates, the Fed won't necessarily follow along. The U.S. economy grew at just a 0.6 percent rate in the first quarter - the weakest in just over four years - though the second quarter looks to be stronger.

Still, Paul Donovan, senior global economist at UBS in London, noted that inflation seems to easing and said he expects the U.S. economy to slow further in the second half. He believes it's actually more likely that the Fed will lower rates eventually, rather than hike them, as many investors now fear.

And when it comes to the global economy, the outlook remains upbeat. The main reason central banks are lifting rates overseas is that global growth has been strong, and isn't slowing as much as economists had expected.

"Globally, growth has in some cases surprised on the upside. You've got a situation where rates are rising because growth isn't slowing relative to where expectations were rather than a situation where rates are pushing down growth," Donovan said.

He expects global growth of 4.9 percent this year, which matches the forecast from the International Monetary Fund. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.