"The unprecedented run in the equity markets has boosted confidence among households and helped solidify the economy's shaky foundations. The improving economic outlook undoubtedly applies increasing pressure on the U.S. Federal Reserve and Bank of Canada to hike interest rates from record-low levels. Are traders and investors ready for the end of nearly free money?" asks Paul Vieira of The Financial Post in an article entitled 'The End of Free Money'. Below are edited excerpts from Vieira's article examining the repercussions such increased rates would have on the economies of Canada and the United States.

Timing and Magnitude Crucial

As Mark Chandler, fixed-income strategist at RBC Capital Markets said, "The next thing now, then, is how we are going to normalize rates. We are at emergency levels, but we are no longer in an emergency situation. So it's a question now of timing and magnitude."

U.S Fed Rate to Rise to 1.00% and Canada to 1.25%?

At present, federal fund futures - which provide a gauge of market expectations for U.S. Federal Reserve interest rates - are pricing in a policy rate of 0.90% by the end of 2010, up from its current target range of 0% to 0.25%. That means markets are expecting roughly 75 basis points to nearly a full percentage point in interest rate hikes. A similar instrument in Canada pegs the Bank of Canada's overnight rate to rise 100 basis points, to 1.25%, in the same timeframe.

Will U.S. or Canada Raise Interest Rates First?

Mr. Chandler adds that the biggest debate in financial markets is what the size of the first rate hike from either the Fed or the Bank of Canada will be with views on the timing and magnitude of rate hikes being all over the map. Complicating matters is the recession that just passed was like no other which might cause central banks to keep rates too low for too long to stoke private-sector demand. To top it off, Mark Carney, the governor of the Bank of Canada, would dearly like to avoid raising rates before his U.S. counterpart for fear of further appreciation in the Canadian dollar.

Will Rise Adversely Affect Stock Valuations?

Regardless of which country is first and which country raises their rates the most, however, investors had better get used to the idea of rising rates, just as they should understand that the great global stock market rebound can't carry on forever.

As a starting point, findings from a CIBC World Markets analysis suggest every 100-basis-point increase in the central bank's overnight rate knocks stock valuations down by roughly 5%. Others differ. David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, for one, says the first few rate hikes following an easing period generally have little impact on the immediate direction of equity markets and Peter Buchanan, senior economist at CIBC World Markets, believes that, regardless of when the tightening starts, the initial impact should be negligible for publicly-traded Canadian companies.

Will Rise Adversely Affect Dividend Paying Stock?

In a report Buchanan recently co-authored, he indicated there's little risk that dividend-paying companies - which tend to be highly exposed to interest-rate movements - would scale back dividend payments in the event of tightening. "If anything, this past recession saw a milder rise in the TSX payout ratio than what we've seen in past economic downturns," the report says. It adds firms are paying out only 40% of consensus 2010 operating earnings in dividends - a smaller amount compared to the previous downturns in the early 1990s and 2000s. That provides some assurance that dividend-paying issuers won't be caught in a trap once borrowing costs rise.

Will Rise Adversely Affect Bonds?

As for asset classes to avoid in an era of pending rate hikes, money managers and advisors appear universal in their dislike of longer-term fixed income. Michael Sprung, president of Sprung & Co. Investment Counsel in Toronto says, "The fear is that when interest rates rise, the prices for long-fixed instruments will fall precipitously."

Mr. Sprung, who believes there's a risk of a double-dip recession, said once interest rates begin to rise "people are going to start to worry about the stamina of this recovery. That could cause commodity prices to come off a little bit, which would be reflected in the TSX."

Still, there are those, such as Andrew Pyle, a wealth advisor and markets commentator at ScotiaMcLeod, who indicate that market participants are prepared for central bank tightening - and would welcome the development. "They are ready to engage that question now, and some market participants would be ready if it meant protecting against even higher interest rates down the road by putting a cap on where long-term borrowing rates and mortgages will go," he says. "We are starting to price in supply risk and inflation risk. If that's not arrested any time soon, then those long-term rates will continue to rise and that becomes a risk for the equity markets, as debt-servicing costs for businesses and households go up." Indeed, a Bank of America-Merrill Lynch report has warned that 10-year yields above 5% could prove "destabilizing" for the markets. What could push such a move are concerns of uncontrolled government spending.

How Soon Will Interest Rates Rise?

Prior to this recession, the prevailing wisdom was that central banks commence policy tightening roughly six months after the unemployment rate peaks. Recent job data in Canada indicate the labour market has indeed stabilized, and there are signs of a turnaround in the United States. Economists at BMO Capital Markets said in a recent note they expect U.S. unemployment to peak this quarter, and have tentatively penciled in a rate hike from the Fed in September. As for Canada, they forecast the Bank of Canada to begin tightening in July, once its conditional pledge to keep rates at 0.25% ends.

Others differ, however, with perhaps the most controversial call of all coming from analysts at Goldman Sachs, who believe the Fed will not raise interest rates for two years. Buchanan maintains that central-bank tightening will not begin until into 2011 saying "We are starting from fairly low rates at this point in time, but one thing to bear in mind is that Canadian corporate balance sheets are in good shape. Debt-to-equity levels are quite low and that means if rates go up, that won't be a lot of stress on companies from a financial standpoint."

Too High, Too Soon?

The bigger impact comes during the final rate hikes in a tightening stage because they tend, more often than not, to push an economy into a tailspin. Perhaps the most stunning example was in 1937-38, when Fed moves to withdraw stimulus pushed the U.S. economy back into a deep tailspin and sent markets reeling.

Fortunately, there's little concern Ben Bernanke, the U.S. Fed chairman who is a student of the Great Depression, would allow history to repeat itself and tighten too soon. The same goes for Mr. Carney.

Really?

Editor's Note: The above article is an abridged and enhanced (where appropriate) version of the original. The author's views and conclusions are unaltered. Lorimer Wilson (editor@MunKnee.com)