Prevailing Interest Rates as Global Financial Shift

Interest rates affects almost every aspect of the economic activity. They are the driving force behind any investment decision and one of the few tools for exercising the monetary policy transmission mechanism by central banks. Access to finance and having adequate funding is of a paramount importance for the success and viability of all the economic units, firms, households, and government. Being competitive in financial terms lies in the discretion of interest rates where we face a growing changing environment. Cost of capital is increasing, and it might be remained in higher levels than before, creating difficulties and unchartered waters for businesses that have never operated in that scenario.

Changing interest rate landscape

We are in a pivotal moment in financial world undertaking a major shift in economic reality. For the last 4 decades 1980 – 2020 interest rates were always going down, increasing the money supply, and fueling rapid growth. At first, the steadily falling interest rates appeared to be a good thing because they reduced the high cost of debt, which was double digits, but they eventually reached a very low level that might not be normal. In the last decade from 2010 – 2021 interest rates were close to zero and in certain occasions even negative, to mitigate the effects of the economic crisis. Governments were able to raise money from the markets at extremely low cost for their social and infrastructure programs and firms raised money with very low cost of capital through issuance of debt, either through loans or corporate bonds, to expand.  

Interest rates were for unusual period of time remained extremely low, despite its emergency character to stimulate the economy. This created arbitrage opportunities for borrowers and penalized lenders that they had to pay “parking fee” to lend their money, due to the negative interest rates. Investors could borrow at 0% (or below zero), invest with low risk at 3% and make good profits with undertaking very low risk. This situation remained unchanged through the Covid-19 crisis when money was needed for economic support.

These long-term low interest rates policies created high inflation and the central banks around the world intervened by raising interest rates to mitigate the raising price levels and put breaks at the economic growth, by limiting the money supply. This higher interest rates continues to exist today, and it seems like according to high level executives and bankers around the world that will persist, even when the inflation problem be under control. Central banks are reluctant of reducing the interest rates any time soon. The historically low rates of borrowing that prevailed prior to the pandemic are not returning. It's possible that higher rates are here to stay.

In the wake of the pandemic, the neutral rate (the real interest rate that would prevail when the economy is at full employment and stable inflation, at which monetary policy is neither contractionary nor expansionary) may have briefly increased. This is demonstrated by the fact that economies have continued to grow at their current rates even in the face of interest rate increases from the FED, ECB, and other central banks. It matters if rates are raised permanently or just temporarily. If the economy can no longer support the current interest rate without slowing down, then higher borrowing costs will be necessary to bring the economy down if it starts to overheat. While most economies have shown resilience in the past year against this aggressive policy tightening, core inflation has remained high in several of them.

When major interest rates movements occur, it always worries me that maybe this is the case of pivotal shift and departure from zero or negative interest rates policies to somewhere higher levels. People for over 40 years considered this as a norm and even more the last decade. Now, above all else, will might have another concern regarding the rising financing costs affecting capital decisions and investments. Opportunities would be decreasing, companies will be more sensitive and concerning with the use of debt financing, demanding more strictly added value for the money spend and higher required rates would need to meet the cost of financing. American Investor and Co-Chairman of Oaktree Capital, Howard Marks, CFA calls this major shift a “sea change”.

Effects of interest rates increase

Higher interest rates raise costs for consumers and companies. The longer that interest rates remain high, the more those costs rack up, eroding corporate profitability. Overleveraged households and companies will face the most significant problems and might be in financial distress, as they are exposed to interest rate risk. Borrowers with floating interest rate loans are going to be squeezed the most. Capital investments will decline as firms will seek better utilization of money invested to maximize returns by spending less money in equipment, due to less available capital and increasing cost of debt, while trying to sustain past performance with less assets and better management. Mergers & Acquisitions would also become limited as the majority of them is financed with debt that would be more expensive, while LBOs will be executed more cautiously without overspending and overpaying.

This will affect real estate too. The largest type of household borrowing, home mortgages, have much higher interest rates now than they did a year ago, which is hurting the housing market and eroding savings. Since higher interest rates cause mortgage payment difficulties to arise more quickly, countries where floating rate mortgages are the norm have generally seen larger declines in home prices. Similar challenges face commercial real estate as a result of declining funding sources, sluggish transactions, and an increase in defaults brought on by higher interest rates.

Refinancing

Debt refinancing would be mostly affected. Many businesses around the world do not pay their debts, they just refinance them. It is a common practice for boosting growth and rapid expansion with the use of leverage without sacrificing cash flows. If a company has a 1.000.000 loan with interest rate of 3% and goes to the bank for refinancing, the bank may refinance it at 6% and for 700.000, not for the entire amount, as there are less available funds for lending at banks and greater cost. This inability of rolling over the debt automatically creates a financing gap that the company is required to cover in an environment of increased borrowing costs. If they cannot find the necessary funds companies might deal with credit default.

Firms do not go bankrupt because of a lack of profits but because of a lack of liquidity. Companies that restructured their debt and refinance their loans during zero or negative interest rates era are pretty much unbeatable in financial terms, and they are in better position to deliver great returns. These days are long gone, and the new environment is more challenging for delivering and sustaining returns.

New opportunities for credit instruments and fixed income assets

There is an inverse relationship between interest rates and bond prices. As interest rates rise bond prices decrease, as new bonds are issued with greater yields, attracting investors, and reducing the supply for the already available bonds. By adding these new bonds to their portfolios, investors can improve returns of their portfolios and diversify risk between asset classes. Many investors nowadays are considering adding debt to their portfolios by investing in bonds or different credit instruments, because they foresee that they can get equity like returns from debt instruments, with lower risk. This is much safer choice as shareholders are residual claimants of an organizations while bondholders have priority claim over the firm’s assets and cash flows.

The job for credit distress funds would, also, increase as maturity gap and interest rate gap will increase and mismanaged debt by some unexperienced companies, because of the new interest rate environment that no one has used to do business in. Funds that manage bad loans or deal with credit defaults could generate massive returns as more debt defaults are on the way. These firms will create new financial instruments and derivatives available to investors willing to undertake high risks and provide hedging to firms. They might be a risky investment, but the expected returns are rewarding.

Past performance is no indicator of future returns

Many of the past success of business and money managers was due to the easy money environment. For more than 40 years it was very easy to raise money for any purpose. With surplus of money anyone can be, in one way or another, successful when they have room for error and margins to overpay. In terms of access to money and loans back then it was an easy world. It was the easy money era. It is not anymore, and we do not know if it would be in the future. It remains to be seen how many of the past successful businesses and investors will sustain their profits and prove their abilities to deliver returns. I think that low but persistent interest rate environment from 2 – 5% might not be manageable from households and firms as they have not learned to operate under such cost of capital, even if there are methods and strategies available for that situation. There are financial instruments to mitigate variability in interest rates and hedge against interest rate risks.

Zero or negative interest rates constantly benefits the borrowers and penalize the lenders and investors, supporting impulsive and reckless decisions. And if you think that they are rich and have room to spend more and earn lower returns, let me remind you that in the financial system pension funds and insurance companies are also function as lenders as the surplus units of the economy, investing saver's money.  The consequences of mismanagement the pensions and the insurance programs are catastrophic for the lives of everyday people and society.

The outcome of this analysis is that interest rates might be lower but never zero or negative. The era of free money and financial recklessness might have come to an end. The money is not free and have a cost that is embodied fundamentally at the time value of money and the existence of required returns. In financial circles, the «higher for longer» doctrine is increasingly being discussed. This might be the price will have to pay for all the previous years of extremely low interest rates. It is a new reality that we all should embrace and rapidly adapt to prevail. This new situation does not mean that it will be necessarily bad for the economy, but it will decern the effective from the ineffective. What is certain is that such a situation brings the world economy into a new equilibrium and will affect all economic units. As John F. Kennedy used to say "a rising tide lifts all boats" demonstrating the effect of economic policies to the entire society.