The era of ultra-cheap money is over

The world is past the peak of interest rates this cycle and the question now is how fast they will come down. The most important of all the central banks, the US Federal Reserve, held rates on Wednesday. Tomorrow it will be the turn of the Bank of England and of the European Central Bank. Insofar as anything is certain in financial markets, they too will announce no change. What should we make of all this?

Well, for a start, the financial markets are already cutting longer-term rates. Remember, the central banks only control the cost of short-term deposits. While their decisions do influence the cost of longer-term yields, the longer the duration of the loan, the less influence they have. Other forces, including expectations of inflation, the demand for money from borrowers and so on, matter more.

Falling yields

You can see that most clearly in government bond yields. Back in October, the yield on 10-year gilts – the amount the Government had to borrow for 10 years – was over 4.6 per cent. Last Monday it was just under 4.1 per cent. On Wednesday it had fallen to 3.84 per cent. When you have to borrow as much as the UK government has to, more than £100bn this year, the fall of more than half-a-per cent in interest rates matters a very great deal. Money spent on interest payments is money not available to spend on public services… and the reverse. In practical terms, it gives the Chancellor more headroom for the Budget next spring.

Much the same is happening in the US and in Europe, for bond yields are falling there too. But of course it is not just governments that can borrow more cheaply. It is all of us. Mortgage rates were already coming down ahead of this plunge in bond yields this week. They will come down further, as this decline in the cost of money feeds through the system.

An uncertain future

But how far? Now the story gets interesting. Right across the world people involved in financial markets are puzzling as to what will happen next year. No one knows. The central banks don’t know, though I expect we will see the Bank of England warning that people should not expect them to cut their rates soon. Having been so over-optimistic about the rise in inflation and having been proved so drastically wrong, the Bank will I expect now err on the other side by being over-pessimistic about the rate at which it will fall.

The markets don’t know, either, any more than they know what will happen to share prices, bitcoin or any other volatile asset. Had anyone been able to predict on Monday morning that gilt yields would fall so sharply by Wednesday, they could have made a lot of money by buying them then and selling them now. (The price of bonds moves in the opposite direction to the yield.) Given the way that markets work, it is perfectly possible that this fall in yields will be at least partially reversed. But what I think we do know is that the era of ultra-cheap money is over.

That will have a profound impact on everything. The UK housing market is interesting because the decline in prices seemed to have stopped and had started to climb again. But then this week Rightmove reported another decline, and predicted they would fall further next year. But if this latest fall in longer-term yields is sustained, that should help lift the market. Anyone rolling over a mortgage will have to pay more than they did a couple of years ago, but the pain will be less than it was for home-owners refinancing last summer.

Much the same logic applies to businesses. Companies that over-borrowed when money was very cheap and now have to refinance their debts are in trouble. The heads of Thames Water warned this week that the company didn’t have enough money to repay a loan for £190m that comes due next April. As executives usually do, they said it wasn’t their fault. They blamed water bills being kept too low by the regulator. But actually, they might have been fine had interest rates remained low and they were able to roll over the debt. There will be many more cases all over the world where companies have misjudged their borrowing costs and are in trouble as a result.

The world economy

That leads to the next issue, the hit to the world economy from rising rates. Just as cheap money puffed up economies, more expensive money has the effect of dragging them down. We have not seen the full effect of this yet, because there is a lag between rates rising and their impact on the economy. As a working assumption that lag is around 18 months, but that is a guess and it may have got longer.

Over in America, there were a lot of predictions of recession next year, but the economy seems to be holding up reasonably well. Here, the worry is more about stagnation than recession. In Europe, the principal concern is the performance of the German economy, which is suffering from weak exports. The big point is that the increases in interest rates that have taken place will slow the world economy. But maybe that will mean inflation will fall faster than expected – which will enable rates to fall more swiftly than expected next year.

So huge imponderables, but one certainty: the peak in interest rates is past… though I doubt the Bank of England people will have the courage to say that.

Need to know

I am always intrigued by the way in which much less attention is paid to bond yields than to equity indices. In headline terms, they are much less exciting, particularly here in the UK given the lacklustre performance of the FTSE100 and the even worse one of AIM and other secondary indices.

Over in the US, the fact that Apple became the world’s first $3trn company (and worth more than all the companies on the Footsie) is a great story. The fact that 10-year gilts are back yielding less than 4 per cent is less of a headline-grabber. But in macro-economic terms, it is much more important, and even more so the corresponding decline in US and German yields (US 10-year treasury notes hit 5 per cent in October and are down to below 4.2 per cent now). After all, the fact that Apple hit $3trn, then fell back to around $2.25trn, did not affect other asset prices or the cost of mortgages. But the movement in bond yields does affect just about everything.

The big picture

My guess is that US treasuries are now within their long-term price range. I saw a calculation looking at 10-year treasury yields, which by the way I rank as the most important single interest rate in the world, and setting these off against inflationary expectations. The result was a real expected yield of between 2 per cent and 2.5 per cent. That feels reasonable on a very long view for a no-risk asset. Take that as an anchor and what does that imply for other asset prices?

I would rank UK gilts as somewhat over-valued. Our yields are a little lower than the US and I think I would want a somewhat higher return. Our inflation performance has been quite a bit worse since the Second World War and while I would love to think that we have changed our spots I can’t really believe that has happened. German yields are too low vis-à-vis those of France, unless you think that the eurozone will break up and Germany revalue its currency. How else do you justify German 10-year bonds at 2.2 per cent and French ones at 2.7 per cent? (Italy bonds are 3.9 per cent, close to the UK.)

Fair pricing

Equities? There is a strong growth premium in the US in that you would be pushed to get 2 per cent dividend yield right now, with the S&P500 offering only 1.5 per cent. On that basis treasuries look a decent part of anyone’s portfolio. But here in the UK the reverse is true because the yield on the Footsie is just under 4 per cent, pretty much the same as 10-year gilts, but of course with no protection against inflation. But then the Footsie has gone pretty much sideways for the past two decades, so may not be much protection there either. Oh dear. In the UK residential property comes out pretty well, though of course past performance is no guide to the future and a lot of buy-to-let investors have been burned by the rise in rates.

Conclusion? I think we are back to fair pricing for bonds. I do prefer global equities, which means half of any portfolio invested in the US because that accounts for 60 per cent of global market capitalisation. But there is now a reasonable case for bonds. Some sort of normality has returned.