What were investors thinking? Interest rates must rise: Don Pittis

So much for the wisdom of markets. Suddenly, on fears that interest rate cuts might be coming to an end, North American markets caught a horrible fright. On Monday, Asia followed suit.

Did all those sophisticated stock and bond traders think interest rates were going to keep going down forever? 

• North American stock markets mixed after Asian sell-off
• Stocks tumble as markets digest prospect of U.S. Fed rate hike

It was as if people had set up tents on a railway line and then all screamed "Eek" when the inevitable train appeared on the horizon.

What? No more free money?

The reason for the market shock, as reported in the financial papers, was that both the European Central Bank and members of the U.S. Federal Reserve hinted that the free money era was coming to an end. 

European Central Bank president Mario Draghi suggested Europe was considering ending the flood of new money into the world economy through the bank's purchase of securities.

There were new rumblings the Fed might actually raise rates as soon as September.

After Friday's sharp decline in North American markets, the sell-off continued in Asia and Europe as markets there opened Monday morning.

Fear is not stupid

New York and Toronto began to recover, but there was a new nervous tone "as doubts over central banks' willingness to add more monetary stimulus hit risk appetite," according to the London Financial Times.

• 'It's not working': Why the old economic rules don't add up any more

Being afraid of more speculative risk at this point is not stupid. Really, the criticism should be reserved for what came before — the speculative loading up on bonds and other assets as interest rates crept as low as they could reasonably go.

A few simple words of explanation for that great majority of us who have only a vague understanding of bonds and interest rates:

When interest rates are falling, buying bonds is smart. To think about why, imagine you had bought a safe 30-year bond back when interest rates were seven per cent. You'd still be getting seven per cent on your money, instead of the miserable few per cent they are offering now.

Bond spectre

As long as interest rates continue to fall, that sounds like a great plan. But as I warned in a more detailed column on the subject last year, everything changes when interest rates begin to rise again.

• The potential bond crisis most people have never heard of

According to something called efficient market theory, while individual traders might make bad decisions, the market as a collective takes all future activities into account. Markets are wise, says the theory.

Unfortunately, there has been some evidence that doesn't always work. The crash of 2007-2008 — when the world's smartest investment banks appeared to be caught by surprise after trading up valueless bundles of mortgage debt, then insuring against their collapse — is just one example. 

Closer to home, the overinvestment in oil at $100 US a barrel in 2014 when it would soon fall to less than half that value and stay there, is another.

Sooner not later

In the case of interest rates, it would be fair to put some of the blame on those creatures of government, the central banks. A free market purist might say the Fed, the ECB and others should never have cut rates so much.

Of course, each time they did that, the central bankers said they were counteracting economic weakness, and each time, the markets cheered. Unfortunately, those repeated cuts helped fan the speculative economy.

In Canada, house prices soared as interest rates fell. World stock prices climbed to new heights even though companies were hardly growing.

Perhaps market traders thought the future of the world economy was just to get weaker and weaker forever and that monetary authorities would cut rates, not just to zero, but below zero and then drop them further and further. It is hard to imagine how that would end well.

Many voices, including JPMorgan Chase CEO Jamie Dimon just yesterday, said rates must rise "sooner rather than later."

As to a September interest rate cut, as I've said before, it seems unlikely that Fed Chair Janet Yellen would want to wade into the U.S. election by shaking up markets shortly before the November vote. 

Chances of a September rate rise seemed even more unlikely after comments yesterday by influential Fed governor Lael Brainard arguing against such a move.

However, it also seems inevitable that one day soon the speculation economy will come to an end and that interest rates will begin to rise. In the longer term, the return to real growth that such a rate rise will signal is good for business, for markets and for ordinary people. 

It is hard to imagine how all those clever speculative traders would be surprised to see the day coming.

Follow Don on Twitter @don_pittis