How the US – and other markets – are getting the jitters over imminent interest rate rises.
Investors could sometimes be forgiven for thinking they have strayed into a parallel universe. Established wisdom has it that the time to buy shares is when profits are rising; when there is an abundance of economic growth and optimism about the future.
But the financial crash of 2008 and the massive economic dislocation that followed changed the rules. Fearful of another 1930s-style depression, central banks flooded the world with cheap money. It was as if the system had suffered a heart attack. To keep it alive the central bankers put it on life support; first to keep it alive and then to help it slowly recuperate.
But the drug of ‘cheap money’ has had side effects. A world of artificially low interest rates puts upward pressure on asset prices as investors search for yield. Property, bond and share markets around the world are at, or are close to, record highs, even in countries where economic growth is weak and the recovery feeble.
And hence the burning question of the day: if economic growth is feeble, what will sustain markets once the artificial stimulus is removed?
In turn, this triggers the counterintuitive reaction of markets. When they see signs that the world’s economy is on the mend, they don’t see it as a good thing. They fear that it will mean the end of the life-support programmes. Hence the bizarre outcome that any sign that we might be getting back to normal may be taken as a signal to sell.
The central bankers now understand all too clearly the risks of moving too fast. The past few months have seen some choppy days and weeks – particularly in the bond markets, when investors thought the Americans were about to raise rates. At first, the Fed seemed not to care too much whether overseas markets had a tantrum, believing it need only concern itself with what works best for the US domestic economy. Now it seems to better understand that, in a globally integrated economy, even problems arising in a small country far away can potentially impact on everyone. Bank of England governor Mark Carney underlined this in April. Wearing the hat of chairman of the Financial Stability Board, he warned that turmoil in the bond markets as investors adjusted to a rate hike could all too easily spill over and do damage to the real economy.
Now fully attuned to the dangers, Janet Yellen at the Federal Reserve, and Carney, keep signalling that the first upwards rate moves are still some way off – later this year perhaps or early next – stressing that when they do come they will be small and gradual, meaning most borrowers should be able to absorb the rise without distress. They add that rates are unlikely to rise to anywhere near historic levels – if there is going to be an earthquake we can take comfort from it being a small one.
It’s a shrewd strategy. Markets don’t like uncertainty but the interest rate outlook is
no longer really uncertain. True, we don’t know precisely when rates will go up, but having been softened up for so long, surely no one could claim it has come as a surprise when it does happen. It is perfectly rational to make investment decisions now which position portfolios for the rate moves we all expect in the coming months. This is particularly the case in bond markets, where rising interest rates unavoidably result in a fall in capital values.
There will be pain elsewhere, too. Household incomes have been squeezed for a long time and, for some, an increase in mortgage rates will be hard to take. Likewise, some companies which would otherwise have gone bust, have been kept afloat by cheap loans – as shown by historically low levels of bankruptcy. They will find it much tougher in normal times.
But the fear of dislocation should not stop us from welcoming a world in which interest rates are no longer artificially low. Savers have borne the cost of the global financial crisis for far too long and have had to endure wafer-thin returns. A rate rise would be even more beneficial for pension schemes, which would see their solvency positions dramatically improved because their actuaries would be able to sign off on higher future returns on their existing assets. That would lift a financial millstone from companies and leave them with more cash to invest and grow. And at an individual level higher rates would feed through immediately into higher annuity rates, which could make a big difference in the future living standards of those with private pensions who are soon to retire.
Above all, investors around the world would be able to go back to making decisions on what they see as the merits of an investment – rather than trying to second-guess the thinking and actions of central bankers (which is, of course, what investors should always do). The interest rate is the market price for money; market prices determine the allocation of resources. We have lived for seven years with a fundamental distortion of the economic price mechanism; and even if we have grown used to it we should not forget that it is a distortion – and ‘normal’ is what we should strive for. Indeed, though there may be casualties and noise in the markets, we should remember the words of US president Franklin D Roosevelt in the 1930s that ‘the only thing we have to fear is fear itself’.
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