Central banks can continue to force interest rates to decline and keep the party going. Looking back to the late 1990s, this is analogous to the venture capitalists continuing to fund unprofitable companies. The current interest rate bubble, and thus the stock market, depends on this path. This is the bet investors are making right now.
Or, central banks can stop their interventions, leaving interest rates to the market. Central banks have to step back at some point, and for the Fed at least, that might be sooner rather than later. The Bank of Japan is also showing signs that monetary policy has reached its limit. When central banks step back, rates will either stay low and stable (the best case) or start to climb.
Stable rates would be analogous to the venture capitalists telling their companies to start making money. The problem then was that the companies were not profitable and needed constant cash infusions. The problem now is that earnings have been declining, and stock appreciation has depended on lower interest rates. With rates stable, markets will have to grow in line with earnings—a big shift from the past several years.
More likely, rates will start to rise again. Here, the argument that lower rates justify higher stock values, a core of the recent advances, will get turned on its head.
At some point, the party ends
Celebrate the good news, by all means, but keep in mind how we got here. One explicit goal of central bank policy action has been to support asset markets—and in this, they succeeded beyond their wildest dreams.
That doesn’t mean supporting markets is their only goal, however, or that they will keep it up.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by McMillan.