The Fed announced in addition to rate hikes for this year there will also be three next year as well...
Europe's Pain Could Be Your Gain
05/21/2010 9:11 am EST
What's happening in the euro crisis is rattling markets and economies around the world. But in the US, it means cheaper loans, lower gas prices, and good news for investors.
In Europe, the euro debt crisis is nothing but bad news.
Riots in Greece. Strikes in Spain. Shrinking paychecks. Unemployment rates of 20%. Rising taxes. Cuts to government services. Hard times for as far as the eye can see.
In the US? Sure, the crisis has sent a shiver through the stock market, but it's also responsible for falling interest rates, cheaper mortgages, and lower gas prices.
In the medium term, the crisis might even lead to sooner-than-expected turnarounds for emerging stock markets from Brazil to China.
Winning and Losing
The euro debt crisis has sent stocks tumbling from New York to São Paulo to Tokyo on worries—well-founded worries—that the crisis will spread from Greece, Spain, and Portugal first to France and then to banks as far away as California.
The People's Bank of China isn't talking, but Beijing's foreign exchange reserves, held increasingly in euro in recent years as China has diversified away from the US dollar, have taken a beating from the 15% decline in the euro. Prices for commodities such as oil and copper have plunged.
But no bad deed goes completely unrewarded. And the euro crisis is actually good news if you're thinking of buying a home in the United States or own a portfolio full of US Treasury bonds.
The crisis could even make US stocks the best-performing in the world for a while.
Further afield, the crisis has fed into a relentless decline in emerging market stocks. The iShares MSCI Brazil Index ETF (NYSE: EWZ), for instance, is down about 13% for 2010, and the Shanghai stock market is in a bona fide bear market, with a better-than-20% decline from its November 2009 high. But for these markets, the euro debt crisis promises an accelerated end to the decline and a quicker rebound. (For more on China's bear market, see my previous column, "China's Dangerous Balancing Act.")
Why Bad News Is Good News
What are the magic ingredients that have turned what is unrelievedly bad news for Europe into good news for US homebuyers, US investors, and developing-economy stock markets?
Lower interest rates and lower inflation.
In the United States, the euro debt crisis has worked like this: The euro's pain has been the US dollar's gain.
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Investors, traders, and speculators fleeing a sinking euro have bought dollars and dollar-denominated instruments such as Treasury bonds. That moved the yield on ten-year Treasury bonds, which many mortgage lenders use as a benchmark, down to 3.34% on May 18.
That's a huge turnaround. The yield on ten-year Treasurys had been on a march upward as financial markets prepared for the Federal Reserve to start increasing interest rates and as bond buyers demanded to be paid more to take on the risk of a falling dollar. From 3.14% on May 15, 2009, the yield climbed to 3.94% on April 9, 2010. On some days, it flirted with the psychologically important 4% threshold. And then, as the euro crisis hit, the yield on Treasurys plunged. In the bond market, where daily changes in yield are normally measured by a few hundredths of a percentage point, the yield on ten-year Treasurys fell by 60 hundredths of a percentage point in a little more than a month. That's a 15% decline in yield. If we were talking about the Dow Jones Industrial Average, we'd be shaking our heads over a 1,600-point drop in the index.
The US Treasury market has seen bond buyers go from worrying about interest rate increases as early as fall 2010 to believing that that the Federal Reserve won't make a move until 2011. Bloomberg's regular poll of economists showed that, as of May 10, the median forecast called for a very modest 0.25 percentage-point increase in interest rates to 0.5% by the end of 2010. That's down from the April 29 median forecast of a 0.75% target rate by the year's end.
Why the change? The thinking is that with the euro debt crisis causing growth in the euro zone economies to slow to 1% or less in 2010, the Fed will be extremely reluctant to slow US growth with interest rate increases and risk stalling the US economic recovery.
The reversal in interest rates has rippled out across the US economy.
For example, mortgage rates have fallen almost as fast as Treasury yields. On May 18, the interest rate for 30-year fixed mortgages was 4.70%, down from 4.79% on May 11, according to Zillow Mortgage Marketplace. The interest rate on a 30-year mortgage hadn't been that low since December.
Good for Housing
Lower mortgage rates are, of course, good for a US housing industry that is still crawling off the bottom. Housing starts boomed in April, according to government numbers released May 18, with builders starting construction of 672,000 homes, well above the consensus projection of 655,000 and the highest level since October 2008. Housing starts remain at an extremely low level, and it's premature to talk about a recovery, but I think it is fair to say that the housing industry is showing signs of stabilization. And that's good news, especially because economists had feared that higher mortgage rates would send home sales and starts back down.
This reversal—a U-turn from rising interest rates and falling expectations that the Federal Reserve will move on rates anytime in 2010—has also turned income investors' strategies inside out. Earlier in the year, income investors were moving away from Treasurys because they thought bond prices were due for a decline as interest rates climbed. Now, however, Treasury bonds promise positive total returns for the year. Yields are still absolutely low, but a 2%-plus real yield—that is the yield of 3.34% minus the 1.1% annual rate of inflation as measured by the core Consumer Price Index—stands up pretty well against the volatility of the stock market right now.
And, of course, the euro debt crisis, with its guarantee of lower economic growth in the euro zone and lower demand for global commodities such as oil and copper, promises to put a damper on global inflation. In the United States, that will be one more reason for the Federal Reserve to put off raising interest rates anytime in 2010. In the world's emerging markets, lower inflation is likely to mean a more rapid end to moves by governments and central banks that have sent stocks in those countries reeling. (For more on how this is playing out in China, see this recent post.)
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Fewer Interest Rate Increases?
Higher commodity prices aren't the only reason that inflation has picked up in China, Brazil, India, and much of the rest of the developing world. (In many of these countries, and in China in particular, there's a little matter of a runaway money supply.) And it will take months of lower-than-expected inflation numbers to convince central banks in emerging countries that they can stop raising interest rates sooner rather than later. But there's a good chance that lower commodity prices will cause central banks planning on four interest rate increases to stop at three.
I think this is especially likely in emerging economies with a strong commodity-export sector. In those cases, stagnant or falling commodity prices will cut into inflation at home and slow the economy as export growth moderates as a result of the euro debt crisis. Brazil is the prime example of just such an economy. Indonesia is another in that group. (For more on plans by the Banco Central do Brasil to raise interest rates, see this recent post on my Web site.)
Right now, the fear that the euro debt crisis will spread beyond the euro zone and that slower growth in Europe will derail the global recovery overshadows any more nuanced way of looking at the results of the crisis. When you're worried that the world is coming to an end, you don't stop to notice that spring has come early this year.
The euro debt crisis is indeed a major economic and financial crisis that will play out across the world. But the complexity of the connections in the world economy pretty much guarantees that bad news is almost never uniformly bad news in every market and for every consumer and investor.
Toward the end of what is shaping up as a very rough 2010, I think investors will have gained enough perspective—which is just a fancy way to say that the fear will have receded a bit—to start to bid up stocks in emerging markets as interest rate increases and inflation-fighting policies end shorter-than-expected runs.
The stock market rallies that will result will be based largely on the strength of these emerging economies. But today's euro crisis will play a part, if only to speed up a return to accelerating growth in the developing world.
At time of publication, Jim Jubak did not own shares of any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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