Simon French: The secondary effects of higher interest rates are worrying policymakers
One of the biggest and most important trends in global financial markets is under strain. Interest rates on government, household and company debt – that have steadily declined for more than three decades – are moving higher. Whilst this reversal has happened many times before, including in 1999 and most recently in 2013, there is a palpable sense of unease that this time it may be different and more sustained. Having flooded capital markets with liquidity during the pandemic, central banks – including the Bank of England – have spent recent weeks signalling a reversal. No-one, central bankers included, know how much pullback will be necessary. But with inflation across many countries running at levels last seen in the early 1980s, central banks are growing increasingly anxious. Whilst higher prices are largely the result of a surge in goods demand and energy prices – making higher interest rates a tool of limited impact – the risk of secondary effects is what has unnerved policymakers.
This matters for all actors in the economy who have taken out debt. For many years now, debtors have been helped by being able to refinance their borrowing at increasingly lower interest rates. Whilst this tailwind to spending power is not going to disappear overnight, this valuable resource in offsetting the current squeeze is slipping away.
The implications are not just for borrowers. Savers must navigate this transition too. Many have been forced into stock market investing by the low interest rates available on cash or government debt. For the last eight years this money has flooded into companies such as Facebook and Netflix, helping drive their shares to ever higher valuations. Since the turn of the year the share prices of these two stock market giants are down by almost a third. Whilst this is not all attributable to higher interest rates, the punishment for signs of slowing earnings growth is severe. Both have disappointed investors in this regard in recent weeks. The investment managers who are responsible for investing your retirement income are now looking at the higher dividend yields offered by energy and mining companies, tobacco companies as well as banks. Suddenly the UK stock market, where such companies make up a larger share, is the best performing stock market of 2022. It was as long ago as 2001 the last time the UK was atop this particular league table. For investors with a strong sustainability bias these are uncomfortable times.
The challenge in the Eurozone looks particularly acute. Some of the difficult political questions regarding monetary, banking and fiscal union have been deferred by the ability of the European Central Bank (ECB) to keep borrowing costs low since the Euro crisis of the 2010-12. It was noticeable that it was the update from the ECB that merely left open the prospect of interest rate increases that spooked the markets more than the Bank of England actually raising its headline interest rate.
For now, policymakers both in government and those charged with regulating financial markets are relaxed. Credit remains relatively cheap and accessible by historical standards and reversing some of the extraordinary valuations, particularly amongst US technology companies, is likely to be good for the wider economy. There is however a nagging suspicion that many of the stress tests on the global financial system over the last decade have been carried out on spreadsheets rather in the heat of a bond market sell-off. Aware of this, the tolerance for a sustained sell-off in debt markets and returning interest rates to levels older Times readers may have experienced, is limited.
Managing Director, Chief Economist