Recent interest rate rises in industrial countries have fuelled speculation that the world is now transitioning to a regime where borrowing costs generally are higher, with adverse implications for equity markets, writes Mohamed El-Erian, CEO of Harvard Management Company and member of the faculty of Harvard Business School, in the FT’s Insight Column on Tuesday.
By late last week, the rate on the US 10-year benchmark had climbed about 65 basis points in just six weeks. In Europe, rates had risen by about 50bp, whilein Japan they had climbed about 35bp from a lower base.
These moves were in response to several -factors, ranging from indications of robust growth in the global economy to comments and actions by central banks signalling their steadfastness in combating inflation.
A further significant rise in rates from here, especially in the US, would serve to undermine a crucial market assumption that has underpinned the robustness of equities and also risky instruments, including private equity and various “yield-enhancing” loans. Specifically, markets have been operating on the view that US rates are essentially “range-bound”.
This assumption has been supported by the view that that there are “self-stabilisers” in the economy. In its simplest form, the argument runs as follows: as rates move towards the bottom end of the range, consumers are more able to refinance their mortgages, thus taking equity out of their homes to support consumption; at the higher end of the range, the boost to consumption is negated, slowing the economy and fuelling expectations of a cut in interest rates.
So has the time come to abandon this assumption? The evidence suggests ‘not just yet’, even if there is greater potential of longer term, two-way instability in interest rates.
Yes, global growth is indeed robust and business investment in the US is picking up.
But the US housing sector is still under pressure and the recent rise in interest rates will add to the challenges. And yes, central banks in emerging markets are starting to look seriously at ways to diversify their asset allocation. But, at this point in time, the changes are at the margin, with data continuing to show the same scale of buying of US Treasuries.
These considerations suggest that the range-bound assumption for US interest rates may hold for now. Having said that, investors are well advised not to get carried away as the assumption will probably come under increasing pressure and may break in the months and years ahead.
