Danger Ahead: Easy Money Is No More

NEW YORK (TheStreet) -- Even after "tapering" has begun, Fed officials have made it clear that monetary policy will remain extraordinarily accommodative for a long period of time. In this sense, "easy money" is going to remain with us for quite a while.

However, the agonizing by financial market participants over the timing and rate of monetary tightening has begun. The "tapering" genie is out of the bottle and it is pretty clear that it will not go back into it without a major accident to the U.S. economy.

So, any way one looks at it, when it comes to speculative profits in financial markets, the "easy money" is no more. Financial markets investors are in for a very volatile ride in the next few months: Either the economy tanks and rates fall/stabilize at a low level, or the recovery proceeds and rates normalize.

The problem with the latter more optimistic scenario is that given the current rate of inflation as well as the stage of the recovery that the U.S. economy is in, a "normal" yield on the 10Y Treasury note should be in the neighborhood of 5.00% vs. the roughly 2.16% rate that prevails currently. Thus, ironically, "normalization" of interest rates led by the Fed implies a severe shock to financial markets as fixed income instruments such as iShares Barclays 20+ Year Treasury Bond ( TLT) , and SPDR Barclays High Yield Bond ( JNK) decline sharply in price as yields rise.

Markets are not going to wait for tapering to occur; markets will become highly volatile as investors anticipate this prospective interest rate shock and its perceived consequences for the economy and financial markets.

It is far from clear how this massive anticipatory adjustment that will be played out in financial markets is going to turn out. The path ahead is highly unpredictable, and potentially treacherous.

On the one hand, the financial markets adjustment could go badly. Credit market dislocations caused by rising interest rate expectations could become so severe that the economic recovery in the US becomes derailed. In this scenario, broad stock indices represented by ETFs such as SPDR S&P 500 ( SPY) will decline severely.

On the other hand, the economic recovery could proceed apace despite sharp rises in interest rates. From this more optimistic scenario, two distinct possibilities arise.

The first possibility is that the inflation of an asset bubble proceeds as many investors deploy excess liquidity in the economy to bid up the prices of various risk assets such as stocks and real estate.

The second possibility is that the rise in interest rates will trigger a concomitant decline in the prices of income producing equities (i.e., dividend stocks) that are widely being deployed in portfolios as fixed-income substitutes and which are currently trading at valuations that are unprecedented.

Such a scenario implies either a decline in overall stock prices, or a massive and messy sector/style rotation (from dividend producing value stocks to non-dividend producing growth stocks) that leaves the prices of the major indices such as the S&P 500 (^GSPC) and Dow Jones Industrial Average (^DJI) relatively unchanged.

If you think you know your way around this prospective financial markets mine field, good luck to you. Simply beware of one thing: As far as prospective returns on equity investments are concerned, the "easy money" is no more.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

James Kostohryz has accumulated over twenty years of experience investing and trading virtually every asset class across the globe.

Kostohryz started his investment career as an analyst at one of the US's largest asset management firms covering sectors as diverse as emerging markets, banking, energy, construction, real estate, metals and mining. Later, Kostohryz became Chief Global Strategist and Head of International investments for a major investment bank. Kostohryz currently manages his own investment firm, specializing in proprietary trading and institutional portfolio management advisory.

Born in Mexico, Kostohryz grew up between south Texas and Colombia, has lived and worked in nine different countries, and has traveled extensively in more than 50 others. Kostohryz actively pursues various intellectual interests and is currently writing a book on the impact of culture on economic development. He is a former NCAA and world-class decathlete and has stayed active in a variety of sports.

Kostohryz graduated with honors from both Stanford University and Harvard Law School.

View Kostohryz's LinkedIn profile and connect with him here; follow him on Twitter here and Google+ here. When connecting, be sure to identify yourself as a reader from TheStreet.

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