Interest rates bewitch markets

If in the next few months inflation rates start to fall away as expected, central banks may be able to go slower on the rate rises than their current rhetoric suggests.

| 6 min read

Much of the bearish action in markets this year has resulted from the words and actions of central banks. Most of them have faced high and rising inflation and have had to report price rises well ahead of forecasts they made a year ago. Most are now starting to raise rates and warning markets of more rises to come.

When interest rates are rising bonds sell-off because higher rates means lower bond prices, as they adjust to the need to offer a higher income relative to their capital value. Shares can also sell-off as analysts work out what higher rates might do to company costs and to demand. The idea behind raising rates is to deter people and companies from borrowing so much to reduce demand financed on credit. It is also designed to squeeze the spending power of all those people and companies that have borrowed in the past and will need to pay more interest if their loans are at floating rates.

Developed-emerging split

The pattern of rates show that the world has been divided into the advanced countries and the emerging markets economies for some time. Rates have stayed a lot higher in the emerging world as inflation has been a more recurrent problem there. Some of these countries have serious problems with very fast inflation, leading to interest rates of 49% in Argentina, 14% in Turkey and 12.75% in Brazil. The Turkish President wants to cut rates as he disagrees with the policy of curbing inflation through money tightening. China and India, with rates of 3.7% and 4%, have kept rates higher than the advanced countries to contain inflation.

The advanced countries managed to keep inflation around 2% for many years after the banking crisis of 2008 with interest rates depressed close to zero. That is now changing fast, as the authorities wake up to the lively inflation that they allowed to develop last year and this. The US and UK are up to 1%, New Zealand has reached 2% and South Korea 1.75%. Most are on a journey to higher rates. Japan is the exception, with rates around zero and still little inflation to worry about.

These rate rises actual and planned have led to bond price falls to increase the rate of interest you can acquire by buying a bond which pays a regular fixed income. The ten-year country bonds in many cases were offered not much above zero during the Covid-19 disruptions, buoyed by aggressive central bank buying of these instruments. Today the yields have risen to more than 3% for the US, Canada, New Zealand and Australia, to more than 2% for the UK and over 1% for Switzerland. Within the Eurozone, German bunds now offer 1.3% compared to zero in 2020, whilst Greek and Italian bonds are well over 3%.

Support props vary

The bond markets are receiving different levels of support. In Japan, the money creation and bond buying continues to keep interest rates down. In the Eurozone too, money creation and bond buying are continuing throughout the second quarter of 2022, though most expect it to end by next month. The Bank of England stopped special bond buying programmes at the end of last year and the Fed at the end of the first quarter this year. There are arguments in all the main places outside Japan about whether and how quickly the central bank bond portfolios should be wound down and by how much short-term rates should be increased.

Markets are implying a lot of rate rises still to come on both sides of the Atlantic..

Markets are implying a lot of rate rises still to come on both sides of the Atlantic. This reflects strong anti-inflation rhetoric from most of the central banks and market fears that inflation is going to prove difficult to shift. Against this, we need to weigh the impact of high food and energy prices on family budgets, and the growing need for companies to compete on price to capture the dwindling discretionary income left over after paying the much bigger bills for the basics. If later this summer inflation rates in most places start to fall away as we pass peak rates of increase in energy, food and other scarce products and commodities central banks may be able to go slower on the rate rises. Longer-dated bonds will perform better once the idea spreads that inflation will recede.

If you look at a 2% or 3% income on a ten-year investment today and compare it with inflation rates of around 8% in America and Europe it looks like bad news. Your real wealth contracts as income falls short of inflation, and this can be compounded by further falls in the price of the bonds. If you think that inflation will be back down closer to targets of 2% in a couple of years, then it does not look so bad.

At a certain point, if progress is recorded with inflation central banks can go easier on rate rises and longer-dated bonds will start to rise again, making them a more worthwhile investment. Much is riding on central bank policy which, in turn, hinges on how successful they are at containing the inflation they have allowed to take hold. We still need more tough actions and tougher words spoken before people will believe inflation is under control.

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Interest rates bewitch markets

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