Interest rate hikes didn’t derail the boom last time

Interest rate hikes didn’t derail the boom last time

The argument is simple enough: As long as real economic growth remains low and liquidity continues to be abundant, the resulting excess liquidity boosts asset prices. But now that central banks have started to make noises about tightening policy on the one hand and as growth revives on the other, that excess liquidity will be wound down and asset prices will no longer gain so much.

Also Read Manas Chakravarty’s earlier columns

But first, a look at the US money market funds. On 28 October, these were $3.37 trillion (Rs158.4 trillion), down from a peak of $3.92 trillion reached in January. The data show that these assets were around $3.4 trillion in mid-September 2008, before the blow-up of Lehman Brothers Holdings Inc. sent the financial world into a tizzy. In other words, the unwinding from that panic-driven stampede into money market mutual funds in the US is now over.

Graphics: Sandeep Bhatnagar / Mint

But our markets are dependent on foreign portfolio inflows. What was the monetary policy stance in the US during those years? After the dotcom bust, the US Federal Reserve lowered interest rates to boost growth and it wasn’t until June 2004 that it started to tighten again by raising the Fed funds rate by 25 basis points to 1.25%. After that it continued to slowly and steadily raise the Fed funds rate till it reached 5.25% in June 2006. We know that the stock market boom continued in spite of the rate hikes.

Nor did rising interest rates in the US lead to money flowing out of emerging markets. That concern had been voiced by many market watchers, based on the experience in 1994, when the turning of the interest rate cycle led to funds flowing back to the US, leading to a collapse of emerging market stocks. The International Monetary Fund’s World Economic Outlook’s database shows private portfolio flows to emerging and developing economies fell from $71 billion in 1993 to $54 billion in 1994 and further to $23 billion in 1995. But, as the chart shows, there was no such fall in portfolio flows in either 2004 or 2005, although 2006 did see substantial outflows. During the late 1990s and the 2000s, the Asian crisis and the dotcom bust, respectively, kept fund flows negative. That said, there is no doubt that markets get jittery when there’s talk of rising interest rates. This was most clearly seen in May 2004, just before the US started raising rates, when emerging markets sold off. The Indian market suffered a double blow at that time, because the election threw up a government dependent on support from the Left. With the benefit of hindsight, we now know that panic reaction to the beginning of interest rate hikes was a great buying opportunity.

What about the argument that it is different this time? Here’s the bull case, compellingly stated by Hongkong and Shanghai Banking Corp. Ltd strategist Garry Evans: “We would point out to investors who want an example of a nastier recession that, in the 1930s in the US, the stock market rose by 371% between March 1933 and March 1937 and that real GDP (gross domestic product) growth was 11%, 9% and 13% in 1934-36. Deep recessions are usually followed by sharp rebounds even if, as in 1933-37 in the US, the long-term fundamental problems have not gone away."

Manas Chakravarty takes a weekly look at trends and issues in the financial markets.

Your comments are welcome at