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Global interest rates are up dramatically since March 2022. But what is the situation now, how does it compare to the past, and what could be next?
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.
The US Federal Reserve (Fed) and the Bank of England (BoE) both decided to hold interest rates this week. That means that, at least for another month, the BoE base interest rate will remain at 5.25% while across the pond, the target rate will hold at 5.25-5.5%.
While this was somewhat expected, the long-term outlook is a bit murkier. Here’s a closer look at eight things investors should keep an eye on from the past and what could be next for interest rates across the globe.
This article isn’t personal advice. All investments and any income they produce will rise and fall in value, meaning you could get back less than you invest. If you’re not sure if an investment is right for you, ask for financial advice.
In 1979, Paul Volker became head of the Fed. US interest rates were raised significantly, sending the economy into recession and reversing the upward trend in inflation. This signalled the peak in interest rates. The BoE and other central banks were made independent of government in the 1990s and adopted inflation targets – usually around 2%.
This enhanced commitment to stable inflation paid off in terms of lowered expectations. Even through the recent spike in inflation, surveys of professional economic forecasters projected that inflation would remain close to target levels over the long term.
The Chinese economy opened up under the leadership of Deng Xioping in the 1980s. Its integration into the global economy significantly boosted the world’s labour supply.
The fall of the Berlin Wall brought the whole of eastern Europe into the world’s trading system. The World Trade Organisation reduced barriers to trade and cut tariffs. These events combined to lower inflation in global wages and goods prices.
As populations aged, people spent less and saved more. In our view this has contributed to lower economic activity and put downward pressure on lending rates.
When crises hit – the bursting of the dotcom bubble and the 2008 global financial crisis – inflation fell. Central banks were quick to cut rates. But slower to raise them as economies recovered. Economic cycles increased in length – and were less volatile. There were no major wars too.
Because economic shocks were deflationary, when they struck bonds rose as shares fell. This wasn’t the case in the 1970s when inflation soared. This is an attractive property for balancing the risks in portfolios, increasing the value of bonds – and therefore decreasing their yield.
In the decade after the 2008 global financial crisis, central banks were fighting deflation, not inflation. They expanded their policy toolkit beyond cutting interest rates. They bought government bonds to push long-term rates down and boost money supply – or quantitative easing.
This combination of factors drove inflation and interest rates lower over the last four decades. The volatility of inflation fell and the premium for holding more volatile long-dated bonds over cash disappeared. Yields on government bonds fell to the lowest levels in history – turning negative in some countries.
The COVID-19 shutdown brought massive monetary and fiscal stimulus. As economies reopened, this stimulus combined with pent up demand to get out and spend. The result – inflation soared.
Price rises were then exacerbated when Russian oil and gas supplies were cut off following the invasion of Ukraine. Short and long-dated interest rates moved up significantly.
Today, inflation remains high, but is falling. Central banks across the developed world are signalling that inflation isn’t beaten yet. They indicate that interest rates are close to the peak, but they won’t cut until inflation is convincingly lower.
When we think about the eight factors that drove rates down in the last cycle, how do these impact the rate outlook today?
Independent central banks and inflation targets intact. Fears that highly indebted governments borrowing will force central banks to lower interest rates are premature – see, for example, the market reaction to the Liz Truss mini-budget, when plans for unfunded tax cuts led to a sharp rise in borrowing costs.
But the benefit from strengthening these institutions was a one-off boost to confidence that can’t be repeated.
Expectations remain stable, as investors continue to believe that – eventually – central banks will bring inflation down towards target levels.
Globalisation has stalled and will no longer be a source of disinflation.
The invasion of Ukraine and the ending of trade with Russia has limited impact. But it highlighted the risks associated with China’s policy towards Taiwan.
Manufacturers are diversifying supply chains to reduce reliance on any one country – typically shifting manufacturing to other emerging nations.
This means we expect economic growth to remain slow. But there are inflationary influences of ageing societies too. A shrinking working age population could put upward pressure on wages.
We think supply shocks are more likely going forward. Even if demand shocks are just as common, we expect the overall effect will be inflationary. Wages act asymmetrically – that means rising with inflation, but not falling when recessions come along.
Holding government bonds hasn’t worked, with shares and bonds falling in tandem as inflation soared.
With future shocks as likely in either direction, hedging shares by holding bonds will be less effective. This reduces the value of bonds – increasing their yield.
Actions by central banks to tackle high inflation include a reversal of the bond buying of the last decade, helping to push bond yields higher.
This means higher interest rates according to the standard economic model – and this model is working again. There’s little prospect of these high debt levels being reduced.
Ageing populations require increased healthcare spending. So too do armed forces in a more hostile geopolitical environment. Tax increases and spending cuts are difficult to deliver without political consensus. And, in the US in particular, politics has never looked more divided.
In 2023, bond yields have risen even as inflation has fallen and central banks have indicated that rates are close to their peaks. The recent rise in bond yields while the BoE rate was unchanged tells us investors are demanding a higher risk premium for owning longer-dated bonds.
1981 - 2021 | 2021 - today | |
---|---|---|
Central bank mandates | ↘ | → |
Inflation expectations | ↘ | → |
Globalisation | ↘ | → |
Demographics | ↘ | ↗ |
Supply or demand shocks | ↘ | ↗ |
Portfolio hedging | ↘ | ↗ |
Central bank bond buying or selling | ↘ | ↗ |
Govt. debt-to-GDP | → | ↗ |
We can be confident on one thing. Inflation and interest rates will be more volatile. This means the top-to-bottom range for both will likely be higher in the next cycle.
In the immediate future, the outlook for inflation is improving. Interest rates have risen for two years. They act with a lag and are helping to bring supply and demand back into balance. This could allow central banks to cut rates next year. We see more risk of recessions than further bouts of inflation in 2024.
But authorities will have a harder job in balancing policies to sustain growth and suppress inflation in the future. A little inflation is helpful in eroding government debt. So, bond holders will demand a higher premium over cash rates for governments who have borrowed heavily.
We think rate cuts are coming in 2024. This will likely mean lower bond yields too. But we think the decade ahead will see higher average interest rates. And more volatile markets.
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This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
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