Thursday, December 7, 2023

Long-term cost of finance is the one to watch

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Inflation, interest rates and the repricing of risk all play a role.
Cameron Bagrie says maybe the best test to apply is the sleep test. If the cost of finance and potential impact on the businesses is keeping you awake at night, then is probably makes sense to do something about it.
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Have we reached the peak in the interest rate cycle? That is a question being put more and more to me. It is the wrong question.

The better question is not whether interest rates have peaked, it is where rates are likely to sit on average over the coming decade. Interest rates move up and down across the cycle; it is the long-term cost of finance across a cycle or two that matters.

I’m in the camp that we are set for higher rates than what we have become accustomed to for the past two decades, and I’m setting my hurdle rates for investment and cash-flow accordingly.  Just to confuse people, higher rates may mean lower rates than now, but still higher than experienced over the past decade. 

The epicentre of this view comes from three judgments.

The first is inflation. The 1990s and 2000s era was called the Great Moderation, the combination of low inflation and diminished economic volatility. Central banks vanquished each challenge every decade by lower and lower interest rates, and more and more money printing.

Secular forces helped keep inflation low. Globalisation. Technology. Low wages, or all power to the employer. Demographics (people saving for retirement) and an abundance of global savings.

All that money-printing has now invariably contributed to inflation, and secular disinflation drivers are not so disinflationary.

Globalisation is reversing. All the power of the employer is now shifting to the employee as the world of labour (and resource) abundance turns into scarcity. The baby boomers are now spending and not saving. Climate change carries inflationary costs. Governments need to contain spending to help battle inflation, but politics and infrastructure investment needs say otherwise.

So, inflation looks stickier, and is requiring higher rates than what we have been used to.

The second is neutral interest rates, that magical number for the official cash rate where central banks have their foot on neither the accelerator nor the brake. It dropped from more than 5% in 2000 to 2% in 2019 according to the Reserve Bank’s mid-point estimate, dragging actual borrowing rates down too across the cycle.

Is the neutral official cash rate still 2%? If it is, the interest rates borrowers face could be 150-300 basis points lower in a few years as normality returns.

Commentators point to Japan’s experience, demographics, and low productivity as reasons for continued low neutral interest rates. Others take a different view. They point to a potential Artificial Intelligence and fifth industrial revolution investment wave as lifting productivity.  There is a bow-wave of global investment needs that need to be addressed too.

Maybe we just got lucky on the inflation front for 30 years, and artificially low inflation meant the same for neutral interest rates.   

The third is the repricing of risk. Do global bonds or credit spreads really reflect the potential for some countries or businesses to default?  Italy’s 10-year bond yields trade around the same as the New Zealand equivalent but their government debt burden is three times higher (general government debt is above 150% of gross domestic product).

Countries around the globe are facing real pressures on finances, yet bond yields do not appear to contain any material risk component.  Witness the current nervousness over the United States’ debt ceiling.

These three secular forces that support elevated rates could be pushed aside in the near-term if we have a global accident. Rising interest rates invariably involve breaking some financial and economic bones, which tends to be followed by lower rates. With inflation rife, central banks will err towards doing too much than too little.

So, what does this mean for borrowers?

We reside in a world of huge interest rate possibilities. Inflation points to rates being elevated for longer, with lower global unemployment rates and strong wage inflation supporting that view, and that is central banks’ narrative. Conversely, the possibility of a financial accident points lower and markets are trading in favour of the later. They have two decades of history on their side but not five. 

Central banks and a few old heads recall the last time we had a spiral where inflation was followed by wage rises, driving more inflation and even higher wages. It is a brutal spiral to break as it involves higher unemployment.

As the economic costs of containing inflation through job losses mount, maybe it becomes tempting to lift inflation targets.  That would just mean higher average interest rates.

The current interest rate curve is inverted (longer-term rates below short-term rates) which means the cost of borrowing certainty has cheapened.

Every borrower’s situation is different. The greater the volatility in earnings and more leverage, the greater the demand could be for interest rate certainty. Conversely, strong balance sheets can absorb interest rate volatility more easily.

Maybe the best test to apply is the sleep test. If the cost of finance and potential impact on the businesses is keeping you awake at night, then is probably makes sense to do something about it.

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