Market Musings 291023: The One Rate to Rule Them All

Summary:

●   Interest rates matter, a lot

●   Long-term interest rates are even more important today

●   Big increase in bond yields since July

●   Competition for investors’ savings

●   Direct economic impact of long-term rates

●   Where next for long-term bond yields

●   Economic contraction in Europe, but growth persists in the US

●   Good chance that long-term bond yields fall

●   Lower bond yields could herald a rally in markets

Podcast this week:

Podcast: The recent fall in stock markets

In today’s podcast, Edmund Shing analyses the recent corrections on the world stock markets:

· An ongoing stock market correction

· The drivers of this pullback in stock markets

· Solutions to diversify a portfolio in this context

Interest rates matter, a lot

Since the end of July, I believe that the one key factor driving stock, bond, and real estate markets have been interest rates.

Interest rates can be divided into two types:

· short-term, and

· long-term.

Short-term interest rates are typically decided by central banks such as the US Federal Reserve, the European Central Bank or the Bank of England. These rates are typically decided on as a function of the level of inflation and growth.

Remember that the central bank's target ultimately is to keep inflation over the medium term at or around 2%. You may of course ask why 2% is the target and to some extent it's arbitrary.

Nevertheless, the fact that central banks have an explicit inflation target of low inflation is important for ensuring economic stability over the medium term

So how exactly do the short-term interest rates work to determine inflation and growth?

The higher the short-term interest rates are, the higher the cost of borrowing is. But equally, the higher that savers are remunerated for keeping money in a savings account. So, there are winners and losers. Borrowers, of course, lose from higher interest rates, while savers gain.

What does this do? It raises the cost of financing of loans, particularly for consumers and, of course, for smaller businesses who depend more on loans from banks and loans which have a shorter payback period. The finance costs of these loans tend to be based on variable interest rates, which in turn are based on the central bank's reference rate.

Long-term interest rates are even more important today

These days, if anything, the global economy is more sensitive to long term interest rates. Now, these long-term interest rates are now not directly determined by central banks, but rather are determined by bond markets.

It is the fixed interest rate or yield that an investor demands in order to lend money, let's say to the government for a fixed amount of time such as five or 10 years, when an investor buys a government bond. Or it is the fixed rate of interest that investors demand to lend money to large companies, again for a fixed period of time - i.e. corporate bonds.

This process is called disintermediation, where companies who are large enough and have a high enough credit rating, can bypass banks and instead borrow money directly from typically large investors via this corporate bond market.

Today, I would argue that the global economy is in many ways much more sensitive to these long-term interest rates, because so much depends on long term interest rates. Firstly, the cost of borrowing for large companies, as I've said. Secondly, the cost of borrowing over the long term for governments is also to a large extent determined by these long-term interest rates.

And thirdly, and probably most importantly for the real economy, there is the impact of these long-term interest rates on real estate markets.

If we think about which markets are most impacted by interest rates, then we should think about which markets make the greatest use of leverage or borrowing of money. Remember that the largest asset class in the world is actually real estate - buying your own house (residential real estate) or indeed investing in commercial real estate, such as offices, warehouses or retail outlets. Both types of real estate purchase rely heavily on long term borrowing of money and therefore, are very sensitive to the prevailing level of long-term interest rates.

Global real estate universe in comparison, 2022

Source: Savills (Sept 2023)

Big increase in bond yields since July

While since the end of July, short term interest rates haven't fluctuated much as central banks have paused their series of interest rate hikes, this in contrast has not been true for long term interest rates i.e. long-term bond yields. This cost at which governments can borrow money for a fixed period of let's say 10 years, has risen sharply since the 31st of July.

In fact, since the middle of July, up until today, in mid-July, the US government could issue a 10-year bond and borrow money at a fixed rate for 10 years at 3.7%.

This was already a rate much higher than the lows seen in 2021 where the cost of borrowing for the US government for this 10-year money at a fixed rate was as low as 0.5%.

US 10-Year Bond Yield has surged since July

Source: tradingview.com

But from mid-July till today this cost of borrowing for 10 years has leaped from 3.7% for the US to 4.8% today, an increase of well over 1% in a matter of 3 months.

Similar, of course, is true in other regions, notably in Europe, where the cost of borrowing for members of the Eurozone has risen sharply. Italy, for example, needs to pay about the same as the US 4.8% In order to borrow money for 10 years at a fixed rate today.

Italian and UK 10-Year Bond Yields have also increased

Source: tradingview.com

Inevitably this has had a significant impact on financial markets in several ways. I think we should focus on the two main ways – via relative valuation of different asset classes, and via its economic impact on growth and inflation.

Competition for investors’ savings

First, there is the impact of so-called valuation. As an investor, you have a choice of where to invest your money. You can invest your money, for instance, in stocks, in bonds, in real estate and a range of other alternative assets.

Now, the attractiveness of each of these will vary largely as a function of interest rates, as bond yields have gone up, the price of bonds has thus gone down and bonds therefore look more attractive.

You know today that you can invest in a government bond at a fixed maturity of 5 or 10 years and receive a rate of interest that is pretty much guaranteed for that timespan.

Bonds have clearly become a lot more attractive to investors over the last few months, as these bond yields have risen and prices have correspondingly fallen.

But this increase in attractiveness of bonds has put pressure on the valuations of other asset classes, such as stocks and real estate. In relative terms they suddenly look less attractive until they fall in price, which is exactly what we have seen as the bond yield has gone up in the US and Europe.

Stock markets have gone down by let's say around 10% on average in the US and Europe at the same time. Stock market valuations have clearly adjusted to these higher bond yields.

And this is because stocks can be seen as what we call a long duration asset, as in much of the value of the stock is not what it delivers to you today in terms of the dividend today, but in terms of its future value. And that future value needs to be discounted at a long-term rate of interest. When that rate of interest goes up, the value in today's money of a stock goes down.

Hence, the 10% correction in stock markets seems entirely logical. Similar can be said for real estate and for other long-term assets, particularly those that depend on leverage (borrowing). The cost of that borrowing has gone up, the pressure on valuations increases, and values tend to fall as a result.

Direct economic impact of long-term rates

But there is a second effect of higher long-term interest rates which has a direct effect on economic activity.

As these long-term interest rates go up, the cost of financing, particularly for companies, tends to go up. Also, the cost of financing for real estate development goes up. And all of this acts as a brake on economic activity, slowing it down.

Because perhaps investments that would have made sense at lower interest rates no longer make financial sense at these new higher interest rates. So then, you see an effect on relative valuation between the different asset classes.

There is thus an impact directly on economic activity, which of course then also can affect the earnings and cash flows of companies, and therefore on the value of these stocks. Similar is true also of real estate investments, particularly for commercial property in economically sensitive segments such as offices, warehouses and retail.

Where next for long-term bond yields?

That explains the correction in the stock and the stock market over the last few months. But what about going forwards? Even if we believe that central banks will not raise interest rates any further in this interest rate cycle?

The real question is whether long-term bond yields can stabilise or fall from today's levels. Or whether they will instead continue to rise and put further pressure on both the economy and on the valuation of financial markets.

In many ways, then, all investors should be watching long-term bond yields, and in particular the US 10-year bond yield very carefully as an indicator of what to expect next in financial markets.

As you would expect, as these bond yields have risen, they have attracted a lot of interest from investors who are perhaps conservative in nature and want to lock in these higher rates of interest for a fixed period of time.

As such, we have seen large inflows of investor money into bonds directly and also into bond funds and ETFs. Given that, up until 2021 investors had been starved of the sort of conservative income opportunities because the bond yields had been so low for so long. These inflows are now perhaps unsurprising, as investors look to benefit from the highest long-term interest rates on offer in the last 10 to 15 years, depending on which country you look at.

Highest US 10-Year Bond Yield since mid-2007

Source: tradingview.com

Where will bond yields go next?

Ultimately, the key fundamental drivers of bond yields are:

a) economic activity, and

b) the rate of inflation,

both of which are tied together.

Economic contraction in Europe, but growth persists in the US

In general, as central banks raise interest rates, they do so in order to raise the cost of financing, thereby slowing down the rate of economic growth.

As they cool economic demand for both consumers and companies via these higher interest rates, they aim to cool inflation through falling demand. This can be observed most clearly in Europe, where economic activity is arguably falling into recession, i.e. economic contraction, as opposed to growth. This is evident from the latest PMI readings where both manufacturing and services have dipped below 50, indicating that they are shrinking as opposed to growing.

Eurozone PMI indices point to weaker economy#

Source: S&P Global

However, in the US, this is rather less clear, particularly given the latest GDP reading for the third quarter up to the end of September, which registered a very healthy 4.9% annualized growth.

Nevertheless, I would argue that this US economic growth is due to slow quite sharply over the next three to six months, and that indeed, a recession in the US is still quite possible or even likely over the first half of next year.

I say this because advanced indicators already point to slowing activity, slowing employment growth. We know that interest rates take time to have their full impact on economic activity.

Source: Conference Board

We should not assume that the full impact of the interest rate hikes put in place by the Fed have had their full impact on slowing the US economy just yet. I believe much of this impact is still to come over the next few months.

I would suggest then, that both growth and inflation should remain low or should slow sharply in the US over the next six months. I believe the same is true in Europe.

Good chance that long-term bond yields fall

This is why I believe that bond yields may be in the process of peaking now, and that these long-term interest rates can potentially fall quite significantly over the next six plus months.

This would no doubt be good news for bond investors, as when yields fall, prices rise. This would also be much better news for stock and real estate investors as the pressure of valuations with ease and perhaps even start to reverse.

This is why I believe that bond yields may be in the process of peaking now, and that these long-term interest rates could decline significantly over the next few months.

Consider what we have witnessed in US long-term Treasury bonds since 2021. The longest-dated US government bonds (20 to 30-year maturities) have fallen over 60% in price terms from their mid-2021 peak.

Italian and UK 10-Year Bond Yields have also increased

Source: tradingview.com

To put this scale of decline in some context, this is the biggest crash in the recorded history of the US bond market, and is far worse than the 50%-odd fall in global stock markets during the 2008 Great Financial Crisis.

Lower bond yields could herald a rally in markets

Seasonality tends to suggest lower bond yields and higher stock markets between now and the end of the year. Should inflation out-turns prove to be on the low side as I suspect, this would certainly help the fundamental case for lower bond yields.

Seasonal trends point to lower US 10-year bond yield by end-year

Source: equityclock.com

Amongst other financial markets, keep a close eye on gold which finally broke back up through the $2000/ounce level this week. Gold looks bullish on other currencies such as euro and Japanese yen, but could well achieve a new all-time high in US dollars too in the near future.

Gold (in US dollars) threatens to break out to another all-time high

Source: tradingview.com

Have a great week,

Edmund