Central Banks May Raise Interest Rates: How to Profit (UUP, PST, TIP)

The Bank for International Settlements, or BIS, warned in its annual report that "highly accommodative monetary policies are fast becoming a threat to price stability" and that central banks will need to raise interest rates in order to keep inflation rates from rising too high and to prevent a real estate crash in emerging markets. After the recent global financial crisis, central banks cut interest rates in an effort to promote growth but according to the Bank for International Settlements' report, the lower cost of borrowing has led to serious financial market distortions. The report goes on to say that the situation is especially critical in the developing world, where cheap credit has led to rising levels of private sector debt, as well as rapidly rising property levels. One major concern is that this may lead to a real estate bubble in emerging economies much like the one that hit many developed nations and led to the financial crisis. Many emerging markets have already taken steps to fight inflation as rising food costs have become major concerns for the governments of countries like China. The BIS report states, "With interest rates rising in emerging markets and at or close to record lows in advanced economies, investors shifted their portfolios towards the assets with higher returns. They did that in part by increasing their carry trade positions in emerging market fixed income instruments. Funded at very low interest rates in currencies such as the US dollar and Swiss franc, these positions are bets that the high interest rate differential will more than compensate for possible countervailing moves in exchange rates." The report went on to say, "The shift of funding has two potentially damaging effects. First, by exerting upward pressure on exchange rates in the emerging market economies receiving the capital flows, it makes their exports less competitive and puts a brake on their growth. For economies that are overheating, this currency appreciation is part of the natural equilibrating process. Second, large gross cross-border financial flows can fuel unsustainable credit expansions and asset price booms. What begins as a response to strong fundamentals can become a serious threat to financial stability." Emerging markets have taken a number of measures in an attempt to slow this currency appreciation, including increasing foreign reserves and adding or increasing taxes on foreigners trading in emerging market currency markets. However, the actions taken by the emerging markets' authorities may not be enough and BIS recommends that central bankers in the developed world raise interest rates in order to remove the imbalances. For the moment, central bankers in most of the developed world seem to be more focused on encouraging growth then warding off inflation but the report from the Bank for International Settlements might be a warning that the priorities of central banks could change in the near future. There are a number of ways to profit once interest rates start to climb back up. If the interest rates in developed economies begin to rise, there will be less incentive for investors to put their money in developing market currencies. If this happens, ETFs like the PowerShares DB US Dollar Index UUP should climb higher as the dollar becomes a more attractive currency. The ProShares UltraShort 7-10 Year Treasury PST is one investment that will respond positively to any increase in interest rates. Once interest rates begin to rise, this ETF will climb quickly but holding on to this ETF long term would be a very risky investment. Investors who like the regular income of bonds but are concerned that rising interest rates could soon hurt their portfolios may want to consider the iShares Barclays TIPS Bond Fund TIP. This is a bond fund with protection against rising inflation rates, so it should appeal to investors who want income and stability.