Interest rates at the heart of the economy
Market actors – from mutual funds to banks, and from hedge funds to insurances - have, for the past decades been laser-focused on a piece of data that can considered to be one of the single most important figures on the planet. This piece of data is the Federal Funds Rate for the US Dollar provided by the United States Federal Reserve System (the Central Bank of the United States). It represents the interest rate at which depositary institutions (banks and credit unions) lend their excess cash reserve balances to other depositary institutions overnight. Central banks outside the US also set interest rates for their own countries. Since the advent of the Euro, the European Central Bank has taken a role of similar importance globally, setting the level of the interest rates for the Euro currency, principally through the Main Refinancing Operations rates and the deposit facility rate.
These interest rates represent one of the pillars on which most of the financial system – and financial instruments - is built. Central banks usually aim at setting interest rates – and therefore the money supply - to balance economic growth and inflation targets, while preserving sufficient liquidity in the financial system.
Any change in the interest rates made by a central bank can have significant impact on the financial markets and on exchange rates and also – over the long term – on the level of economic activity across the globe.
Ever since the great financial crisis of 2008-2010, interest rates of the main central banks have been kept at very low levels, in part due to the fact that inflation has remained low, despite programs of Quantitative Easing (QE) on both sides of the Atlantic. The sudden lack of liquidity on the markets at the height of the crisis in 2008 marked the start of QE programs, through which central banks aim at injecting liquidity in the economy through the purchase of financial instruments like bonds or notes. The use of these programs has been expanded in the US, in the Eurozone, but also in Switzerland, in the UK and in Japan over the past 10 years.
But the unprecedented circumstances related to the Covid-19 crisis have made 2020 a peculiar year, with most developed countries reducing interest rates further close to zero – and even below zero in Japan or Switzerland. New large QE programs have also been launched to support the economy.
The US Federal Reserve System even indicated recently that they did not intend to increase interest rates before 2023 even in case of resurging inflation. Such a decision has been dubbed “Lower for longer”, indicating that investors and businesses should get used to living with near-zero interest rates.
Such a situation matters for investors on multiple levels, regardless of the asset class in which they invest.
First and foremost, as the quintessential low-risk asset class, fixed income investments are poised to see decreased returns in such a period. This means that investors looking for substantial return will need to increase their investments in riskier asset classes, either in fixed income instruments that offer higher interest rates and of course a much higher risk exposure – or by switching from fixed income to asset classes offering a fundamentally different profile, like equities.
Through a lowering of interest rates, central banks can nudge investors to allocate more capital to equities. In the short run, companies should benefit from lower financing costs and ample availability of capital to fund investments or even acquisitions, which should provide a boost to net income. Through better financial results and significant reallocation of capital toward equities, valuation of equities tend to increase, which in turn will reduce the yield of equity investments. However, generally speaking, equities offer a substantially higher risk for investors than fixed income, and the analysis required for thoughtful investment in equities – whether listed equities, private equity or venture capital – is significantly different. Furthermore, high equity valuation levels require even more discipline and analysis ahead of investment.
Low interest rates over a long period provide incentives for individuals and businesses to borrow more, which increases the volume of money circulating in an economy. When this increased monetary supply starts to get redistributed to employees through higher wages, consumption can increase. At this time then, the risks of inflation become substantially higher.
Ever since the mid-90s, inflation has been an afterthought in the daily lives of most investors in developed economies. As a result, a possible rebound of inflation could have significant impact on consumers’ behavior but also on how equities and fixed income assets are valued. Such change could lead to significant reallocation of assets across sectors and asset classes with potentially large impact on investment portfolios and the viability of some business models.
Wealth management clients are facing an unprecedented investment landscape. The combination of the lowest interest rate environment in living memory with low inflation, an increased money supply in the economy, and central banks being comfortable with renewed reasonable levels of inflation, all set the stage for a new investment paradigm. Investors must also take into consideration the uncertainties related to the health crisis, an accelerating wave of technology-driven societal changes, renewed geopolitical tensions and the imperatives - and opportunities – of the sustainability transition.
The complexity of this economic and financial landscape requires dedicated professionals who can offer a holistic view of the situation and an in depth understanding of these trends. Against this backdrop, our DNA at BNP Paribas Wealth Management matters. We assist our clients in understanding the opportunities from this complexity.