A series of aggressive rate hikes from the central banks have redrawn investor roadmaps. What are the consequences, when will things return to “normal”, and what is a normal interest rate?
After the financial crisis of 2008/09, central banks across the world slashed interest rates dramatically to help governments and financial institutions weather the crisis. In many countries, monetary policy remained highly accommodative long after the crisis had subsided, however. As a result, both short-term and long-term risk-free interest rates declined to zero or below it – and stayed there. The long-lasting presence of cheap money led to a surge in wealth and happy home owners.
Ten years later, the Covid-19 crisis served to further extend the period of ultra-low interest rates, but the supply shocks and energy crisis that followed on the war in Ukraine finally woke the ghost most feared by central bankers – inflation.
As a result, interest rates rose by about 4.25% in 2022, the sharpest increase in a year since the early 1980s. The end of cheap money has been mourned by many, particularly in the US stock market, which saw its worst decline since 2008 amid the disappearance of the belief that the Federal Reserve would always come to the rescue if stocks tumbled. Now it looks as if we’ll be waving goodbye to TINA, the popular acronym for “there is no alternative” to stocks when interest rates are at rock bottom.
Cheap money’s funeral caused similar grief in the bond market, where total returns in 2022 were the most negative on record. Even the Treasury’s inflation-protected securities, the bonds known as TIPS that are meant to shield retail investors from the damage that inflation does to savings, lost almost 12%.
Pros and cons of high interest rates
Is the mourning of cheap money justified? Higher interest rates certainly make it more expensive for consumers to borrow, they hurt businesses by slowing consumer demand and make it harder for a debt-laden government to balance the budget. The value of stock and bond investments also tend to be depressed: The MSCI World stock market index fell 17.73% in 2022, while The Bloomberg US Treasury Index posted a 12-percent decline, or more than triple the size of the previous worst year’s, which was 2009’s total return of -3.57%.
However, would doing nothing really have been better? The purpose of higher interest rates is to fight inflation, which – if left unchecked – may ultimately lead to devastating consequences for society and trigger upheaval and wealth redistribution on an unprecedented scale.
Such a threat makes it likely for central banks to keep on tightening until the phantom menace has disappeared. And, as core inflation is dropping, so is the pace of increase in rates. On February 1, The Fed increased its benchmark interest rates by a quarter of a percentage point, marking a return to a slower, more orthodox pace of rate rises.
The Fed’s shift reflects the fact that inflation appears to have peaked while the economy is starting to slow. The increase brings the federal funds rate to between 4.5% and 4.75%, the highest level since September 2007.
Humans tend to be short-sighted and many find interest rates of this magnitude outrageous. But, given that the Fed Funds rate has averaged 4.88% over the past 50 years, it’s not. This perspective tells us that interest rates are still below “normal”.
In addition, cheap money in the form of near-zero interest rates acts like any other drug, wreaking havoc to the system under the veneer of bliss. Over the last decade, the body of empirical literature exploring the adverse effects of the low interest rate environment has grown significantly.
Opportunities for investors
Studies document how the post-crisis period of very low interest rates has contributed to the build-up of financial vulnerabilities and imbalances, resulting in higher systemic risk. These financial vulnerabilities exacerbate the impact of adverse shocks on the economy and can thus deepen economic recessions or crises.
Keeping interest rates low for a prolonged period can also lead to over-indebtedness of the economy, overvalued asset prices and undervalued risks, misallocation of resources and credit, and lower overall productivity. In addition, a sharp increase in the value of stocks and properties tend to widen the gap between the haves and have-nots of the world, which in turn may exacerbate polarization and conflict.
How, then, should an investor act in this new setting? Bonds, the long-overlooked alternative to equities, are now offering the types of yields that have Wall Street gurus advising investors to add a larger helping of fixed-income assets to their nest eggs than they have in years. Some are rethinking traditional strategies such as holding 60% of investments in stocks and 40% in bonds. UBS, for example, argues that “The recommended equity-bond portfolio is much closer to 35-65 than 60-40.”
The new roadmap following on higher interest rates present investors with new options. Investment-grade corporate bonds, now sporting yields of almost 6%, are one example, and Bank of America is expecting total returns of about 9% for US blue-chip corporate bonds this year. A Bloomberg index tracking high-grade and junk-rated government and corporate bonds around the world has returned 3.3% so far in 2023, putting it on course for its strongest January since its inception in 1999.
Investors who want to generate attractive returns with less risk certainly benefit from higher rates. In late December 2022, US Treasuries with short maturities, which are considered to have less risk than many types of investments, were yielding 3.94% to 4.61%.
Alternative asset classes burgeon
Last year’s market turbulence meant private equity also ran into trouble financing deals. As a result, a lesser known asset class as private credit has blossomed. Pension funds and investment firms with lots of money to put to work have flocked to private debt, which is not open for smaller investments.
Stocks in energy infrastructure and property are other assets that may benefit from the new roadmap with scarce energy, high electricity prices and higher interest rates.
When will the turbulence settle? Market observers disagree on whether we are seeing a temporary calm before the storm or if the storm has subsided for the time being. Former US Treasury Secretary Larry Summers, for example, warns investors to brace for a new period of debt, tumult, and volatile interest rates.
“Market bulls have been optimistic that the central bank could dial back rate hikes later this year, sparking a new stock market rally. But investors in the past have been wrong to assume market conditions will return to normal ”, Summers said, pointing to false expectations after World War II that the economy would return to stagnant growth and sluggish interest rates.
In Europe, Philip R. Lane, Member of the Executive Board of the ECB doesn’t think we’re going back to super-low interest rates. He told the Financial Times in January: “The inflation shock has proven that inflation is not deterministically bound to be too low. So, if expectations have now re-anchored at our 2% target, compared to being well below it, interest rates will go to the level consistent with that target, not back to the super-low rates we needed to fight below-target inflation. For nominal rates, that makes a big difference.”
At any rate, interest rates are back. While it’s difficult to pinpoint what a ‘normal level’ for interest should be, we know for sure that money having no price is abnormal.