Markets in turmoil as interest rates rise

Markets fell sharply last week as the Federal Reserve announced that it may reduce the pace of its bond purchases by the end of this year and monetary conditions tightened in China.

In the United States, the Standard & Poor's 500 Index fell 2.1 percent last week. It fell 1.4 percent on Wednesday, the day Federal Reserve Chairman Ben Bernanke announced his plan to reduce bond purchases later this year and end it in 2014 if the economy and unemployment rate continues to improve as forecast. The S&P 500 fell another 2.5 percent on Thursday before rebounding slightly on Friday.

In Europe, the STOXX Europe 600 Index fell 3.7 percent last week. It was the biggest weekly fall in 13 weeks and the fifth consecutive weekly decline.

In Asia, the MSCI Asia Pacific excluding Japan Index fell 4.5 percent last week, the biggest fall since May last year. However, the Nikkei 225 bucked the global trend, rising 4.3 percent after having fallen in the previous four weeks.

The direct impact of the Federal Reserve's plan to taper bond purchases will, of course, be on bonds. US Treasuries fell last week, with the 10-year Treasury yield rising 40 basis points to 2.53 percent. It was the biggest increase since March 2003. The 30-year Treasury yield rose 28 basis points, the most since August 2009, to 3.58 percent.

It was not just monetary policy in the US that affected markets last week. Interbank lending rates in China spiked last week, with the overnight Shanghai Interbank Offered Rate jumping 527 basis points to a record-high 13.44 percent on Thursday.

The People's Bank of China eventually injected funds into the financial system on Friday, causing the overnight SHIBOR to plunge 495 basis points to 8.49 percent. Nevertheless, the slow response from the central bank to the rate spike suggested to some that it was not averse to tighter credit conditions.

However, despite the increase in interest rates last week, none of the most important central banks have actually started tightening monetary policies. Last week's market turmoil essentially resulted from just the expectation for a reduced pace of monetary stimulus. It shows how sensitive markets have become to the course of monetary policy.

We should expect even greater volatility if and when markets perceive impending tightening from the major central banks.