The Fed strikes! It didn’t seem like much. Two weeks ago, Federal Reserve Chairman, Ben Bernanke, outlined his expectations for economic progress, the subsequent withdrawal of quantitative easing, and future interest rate increases. Even though this outline was contingent upon his economic forecast, many market participants took this to be a clear and present warning that rates would soon be rising and decided to sell. They sold bonds, they sold stocks, also commodities and virtually every other asset class; it was across the board.
Selling bonds makes sense if one expects rates to rise. However, stocks should benefit from the better economy and so should commodities; so why were they sold so heavily? One explanation is that a lot of aggressively managed money had used a lot of leverage, (borrowed money), to buy stocks and commodities. When interest rates began to rapidly rise, they simply had to reduce their borrowings by selling the assets to repay the debt. That put pressure on all asset classes.
Another explanation as to why everything was sold was that many investors do not have confidence that the economy can grow without the huge amount of stimulus the Fed has been putting into the system. They ignored, or didn’t believe, that the withdrawal of stimulus was contingent upon certain economic or business cycle improvements.
Another concern arose from China. It initially appeared that the banking system there was under great strain as evidenced by a spike in inter-bank interest rates. Inter-bank rates spike when there is more demand than supply and can mean that something is going wrong. As it turns out, the Chinese central bank engineered this spike in rates to discipline and warn the banking system to be more careful in extending credit. They may be trying to pre-empt a rise in credit problems.
However, China’s banking system is insular and has little impact on our banking system or those of the rest of the world. As for the economic impact, it has some, but far less than the fears suggested. Except as a source for cheap goods, the U.S. makes very little in its trade with China.
So we have had a correction. The catalyst was the fear of higher interest rates. It really was not very deep; between 5% – 7% depending on which index is measured. It was quick, violent and soon over; so what now?