Watch out – higher interest rates are on the way

140704-janet-yellen — Janet Yellen: following the Greenspan way

The US jobs market is picking up another 288,000 people were in work by the end of June.

That means all else being equal we can expect monetary policy to keep getting tighter.

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And that could be a very big deal for complacent markets.

The return of the maestro

Yellen has already made it clear that she doesn't believe the market is in a bubble just now. And even if she did, she doesn't believe in popping asset bubbles with the blunt tool of interest rate policy.

That's the Greenspan way. Pretend that it's impossible to see the bubbles inflating in front of your face. Then, when they pop, clean up the mess by blowing up another bubble in some other asset class.

You can see why the market likes her so much.

Trouble is, this desire to keep rates pinned at near-zero percent is getting ever trickier to justify. Jobs data is picking up. Inflation is rising too. As James Mackintosh points out in the FT, "if prices keep rising as they have for the past three months, the annual rate would be more than 3%".

At some point, even Yellen is going to have to throw in the towel and accept that the money-printing has to stop and that rates may just have to rise. Regardless of how fragile she fears the underlying economy might be, it can't run on emergency monetary policy forever.

The Fed is already behind the curve'

In fact, the reality is that the Fed is already behind the curve. Objectively measured using the cyclically-adjusted price/earnings (Cape) ratio, the US stock market is very expensive. In the past, we've only seen it get this expensive ahead of a crash.

If you buy a market when it's expensive, history suggests that you can expect very low (or sometimes even negative) long-term returns. So for now at least, the one thing that just about justifies it being at these levels is the fact that interest rates are near zero.

That has left investors willing to accept very low likely future returns because they can't expect to get anything better from anywhere else.

But if the Fed or the market (in the form of rising Treasury yields) starts to raise interest rates, then other assets become more attractive. Stocks will have to offer higher returns in order to compete.

They might be able to do that if the economy is recovering, but at current prices, it would take a big jump in earnings for prices to start looking reasonable again. And given that corporate profit margins are already historically high, it's hard to believe that profits can improve dramatically.

For now, the market is still assuming that the Fed will do all it can to keep rates low for as long as possible. It's a reasonable assumption but the risk you take for betting on that assumption grows higher every day that the market keeps rising.

So I'd be avoiding the US stock market. I'd stick with better value markets like Japan. I'd also be very wary of bonds. Tighter monetary policy could well be toxic for conventional bonds (their prices will fall as the fixed coupon payment they offer becomes less attractive).

But it's probably worth getting some exposure to the US dollar if you don't already have some. You don't have to do anything complicated many of the FTSE 100's blue-chip stocks have heavy exposure to the US, meaning that a stronger dollar results in improved results when converted back into sterling.

We look at some ideas for what to put into your portfolio right now in my colleague Ed's cover story on the new Isa, in this week's MoneyWeek magazine. If you're not already a subscriber, you can get your first four issues free here.

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