How assets prices react at the start of monetary tightening

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By Shavasb Bohdjalian

The German conservatives lost power in a regional stronghold on Sunday, with early poll results showing the Greens, buoyed by Japan's nuclear crisis, surging to their first premiership in the Baden-Wuerttemberg state.
This capped off a barrage of bad news for the euro last week including the collapse of the Portuguese government, the ensuing credit ratings downgrade and a delay by euro zone leaders to increase a rescue fund.
Still, the ECB seems to be on track for a rate hike in early April with Governing Board member Ewald Nowotny on Sunday saying it wanted to move towards a more "normal" monetary policy despite recent events in Japan.
Philadelphia Federal Reserve Bank President Charles Plosser, a well-known inflation hawk, said on Friday the U.S. central bank will have to reverse its easy money policy in the "not-too-distant future" to avoid sowing the seeds of inflation.
Plosser's comments were supported by St. Louis Federal Reserve President James Bullard, who said on Saturday that lengthening the "extended period" of low interest rates could encourage a liquidity trap.
So with the ECB expected to hike rates in two weeks' time and the Bank of England expected to follow not long afterwards and the Fed reversing its loose monetary policy, the million dollar question is how different asset classes react at the start of the monetary tightening cycle. According to an analysis by Commerzbank, in previous cycles, equities have recorded above-average gains in the first nine months following the first rate increase, industrial commodities have posted above-average gains over an even longer horizon, whereas government bonds and precious metals have tended to underperform.
The Commerzbank research findings show that market players do not regard initial rate hikes as the beginning of the end of an upswing but more as confirmation of a robust economic recovery. In other words, central banks are sending a signal confirming the strength of the economic upswing. During the first nine months after the start of a tightening cycle, equities generally show a solid performance. For example, the MSCI World index generated an average outperformance of c. 6% in the nine months following the start of rate hike cycles. Selected commodities such as base metals and energy (above all, oil) have shown above-average performance well into the cycle.
The same cannot be said of gold. With the first rate hike, central banks are signaling that they want to counter any possible rise in inflation. This makes precious metals such as gold less attractive as safe havens. Moreover, higher interest rates make gold a less attractive prospect on account of the resulting loss of interest income (since gold does not earn interest, an increase in the yield on interest-bearing securities raises the opportunity cost of holding gold).
Higher interest rates, and correspondingly higher bond yields, mean that bonds under-perform in the 24 months following the start of the monetary tightening cycle. Since 1970, the yields on ten-year Treasuries, for example, have risen by an average of 127 basis points in the 12 months after the Fed's initial move, and Bund yields by 58 points, the Commerzbank research shows.
As for the euro, the Commerzbank analysts say that if Portugal taps into the rescue fund, the short term effects on EUR-USD will depend on the likelihood that Spain will need to take similar action, but this does not seem imminent at present.