How the ECB’s Actions Could Boost U.S. Markets
Not too long ago, the European Central Bank (ECB), to fight the economic slowdown in the eurozone, lowered its benchmark interest rates. The hope with this move was the same as it was in the U.S., England, Japan, or other countries that are facing economic scrutiny: lowering interest rates will eventually increase lending and eventually bring in economic growth. In addition to this, the ECB also announced that it will be taking part in an asset purchase program—something similar to what was implemented by the Federal Reserve.
When I look at all this, it creates a very interesting situation. The ECB is lowering its interest rates as the Federal Reserve and others, like the Bank of England, are building grounds to raise their benchmark interest rates.
For example, the Bank of England is hinting at raising interest rates by spring of 2015. The governor of the central bank, Mark Carney, recently said that if interest rates were to rise in the spring as the markets expect, this move would allow the bank to meet its mandate regarding inflation and jobs creation, according to its forecasts. Simply put, the bank is prepared to raise interest rates early next year. (Source: Hannon, P., “Bank of England Gov. Mark Carney Signals Spring Rate Rise,” The Wall Street Journal web site, September 9, 2014.)
And the Federal Reserve may do the very same.
With this in mind, I question where the next big trade is going to be.
Remember what happened during the financial crisis, when the Federal Reserve and other central banks lowered their interest rates? In search of yields, the easy money that was available in the developed world moved to emerging markets. The trade was very simple; you could borrow money in the U.S. for instance, say at three percent interest, and then invest it in the emerging markets, like India, for six percent interest. At the end of the day, your net return would be an easy three percent.
With the ECB lowering rates, I see something similar happening—investors borrowing in the eurozone and investing elsewhere. But, I don’t think the money will be going towards the emerging markets as much as it did after the financial crisis. I see the money flowing into the developed countries instead, such as the U.S. and England, which are looking to raise interest rates.
Why will this happen? When the central banks in countries like the U.S. and England raise interest rates, investors will have the opportunity to invest in quality assets. For example, if the Federal Reserve raises interest rates, it can have serious consequences on U.S. long-term bonds (bonds don’t do well when the interest rates rise). For investors who can borrow at a much lower rate, they may be able to take advantage of this situation by buying U.S. bonds at much higher yields…later on.
If investors believe this scenario will play out, they can take advantage of this in many different ways. One way they can do this is by looking at exchange-traded funds (ETFs) like the Vanguard FTSE Developed Markets ETF (NYSEArca/VEA). This ETF follows the equity markets in the developed countries, offers a yield of more than three percent, and holds equities from areas like Japan, the United Kingdom, and others. (Source: “Vanguard FTSE Developed Markets ETF (VEA): Portfolio,” Vanguard web site, last accessed September 17, 2014.)
Investors may also look into the iShares 20+ Year Treasury Bond (NYSEArca/TLT) ETF, which follows the performance of long-term U.S. bonds. Once interest rates start to move, these bonds will become attractive to investors, meaning profits for those who act now.