Hamish McRae: Wise course is to expect the unexpected on interest rates

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8 October 2018

This will be an important week for US bond markets — and because everything in financial markets is linked, for global interest rates and asset prices.

Last week was a bit of a bloodbath. On Friday the yield on 10-year US Treasuries rose to within a whisker of 3.25%, having started the week at just over 3%. That is the highest level since 2011, but it is the pace of change that is so dramatic. Some people will have lost a lot of money; others, for such is the way of the world, will have made a lot.

If that does not bother you too much, think of the knock-on effects.

It is as though you were planning to buy a house and you had agreed in principle a mortgage fixed at 3%.

You go in to sign the papers and the lender says, “Sorry chum, I’m afraid it is going to cost you another quarter per cent, and you had better hurry because it may be more next week”.

Suddenly those monthly payments look more of a squeeze. And since it is not just you, but every house-buyer in the land, what does that do to house prices?

Of course the links are fluid. The 10-year US Treasury rate is the most important long-term interest rate in the world, but it has only an indirect effect on rates here, in Europe, Japan, or the emerging economies.

But the effect is there: the low for 10-year gilts last week was below 1.4%, but on Friday they closed at just under 1.6%. In historical terms that is still very low — I think absurdly and artificially so — but it is being pulled higher by America.

This is global. Here and in Europe (where at last the European Central Bank is starting to tighten policy) we can tolerate or even welcome higher rates. But in much of the emerging world this is serious.

The point was well put last week in a note from the South African bank, Nedbank Group. Its analysts wrote that “a stronger US dollar and the global cost of capital rising is the perfect cocktail, in our opinion, for a liquidity crunch”. It would follow that in the emerging countries, at least, there will be distressed sellers of assets, who have to sell something because they cannot raise the cash to keep afloat.

What happens next? Well, the US markets are closed today for the Columbus Day holiday, and that will give pause for thought. In any case after you get a sudden lurch such as we saw last week you usually get some sort of rebound.

There may be enterprises that were wrong-footed last week and are in more trouble than anyone realises, but these will be specific instances. Nothing is certain in the investment world but the story is likely to be one where the rising cost of money puts a damper on asset prices, rather than provoking a crash.

But what is glaringly clear is the way US markets have detached from the rest of the world. The average dividend yield on the S&P500 companies is 1.8% — way below the 10-year Treasuries. The dividend yield on the FTSE 100 is 4.2%, way above the 10-year gilt yield.

This divergence won’t persist. The US equity market is artificially inflated by the very high valuations on high-tech shares and by the sugar rush of the Trump tax cuts. The UK market is artificially depressed by the uncertainty (and I think the excessively negative comment) about Brexit. But whatever happens to share prices, global interest rates, led by the US, have turned. The 30-year bull market in bonds bottomed out two years ago and we are in the early, and inevitably bumpy, stages of a return to normality.

Never say never, but I think it extremely unlikely anyone alive today will see rates as low as they were two years ago. I used to think they were the lowest in recorded history, but I have just seen a commentary by Yolande Barnes, head of Savills World Research, in which she wrote that they fell to zero after the Black Death had killed half of Europe’s population in the 14th century.

Well, Europe’s population may be ageing but in most countries it will carry on growing for a bit yet — and the UK’s population outlook remains more positive than that of the Continent. Barnes’s view on property is that rising interest rates need not inevitably reduce capital values for several reasons, including the fact that there is a limited supply of property assets in which to invest.

My worry is that a whole generation of people have never experienced a steady rise in interest rates, and that therefore they are unprepared for it. The danger next year — here in the UK and elsewhere — is not so much that rates will shoot up suddenly, though that movement last week on the US bond market was a useful warning. Rather it is that they will rise to steeper levels than people expect.

Hamish McRae: Wise course is to expect the unexpected on interest rates

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