The rise in interest rates over the last two years has been dramatic. UK interest rates have risen at the sharpest pace since the 1980s, while rates in Europe have rapidly increased from negative territory to the highest level since the inception of the euro.
Evidently, this sharp rise in rates is good news for corporate treasurers. The yield available on short term liquidity strategies has moved higher very quickly.
With rates rising rapidly, longer duration securities would just have locked in lower yields for longer and exposed investors to price volatility as yields rose. Step out strategies that can take more duration risk therefore had a tough job just to keep up with short term liquidity strategies and could easily have underperformed if they held too much duration.
But we now believe that we are at or extremely close to the peak in interest rates, both in Europe and the UK.
That changes everything.
Now, the opportunity to step out and extend duration beyond that permitted by short term liquidity strategies offers the ability to lock in these much higher yields for longer and benefit from price appreciation if rates start to come back down.
One side effect of the rapid nature of the recent rise in rates is that the full force of the monetary tightening probably hasn’t been felt yet by the economy. That is particularly the case in the UK, where short term fixed rate mortgages temporarily protected borrowers from higher mortgage rates. However, every month more and more of those fixed rates are expiring, leaving households facing very significant increases in their mortgage payments when they refinance.
In Europe, mortgages tend to be fixed for longer than in the UK but monetary policy still acts with a lag. As higher interest rates affect both business and consumer decisions, the economy could still weaken further.
While inflation remains uncomfortably high, a weakening economy in both the UK and eurozone, could cool the labour market and bring down wage growth. This in turn could help moderate core inflation pressures.
Evidence that the economy is already weakening is clear in the PMI (Purchasing Managers’ Index) business surveys. Both the manufacturing and service sectors are contracting in the UK and Europe, which tends to suggest that a recession is around the corner.
The good news is that even when interest rates do get cut, we don’t expect them to return to the extremely low levels seen for most of the post financial crisis period. Structural supply issues relating to the ageing of both the Western and Chinese labour force and to commodities and the energy transition, as well as reduced political support for both further globalisation and austerity, mean inflation and interest rates are likely to remain higher than in the post financial crisis period.
However, that doesn’t mean rates will stay quite as high as they currently are for the foreseeable future. There are still likely to be cyclical ups and downs around a structurally higher level of inflation and interest rates.
So if, like us, you think we’re near the peak for interest rates, it’s time to be bold and consider stepping out into standard or ultra-short duration strategies that can lock in higher yields for longer and outperform when rates get cut.
Nobody knows exactly how soon the first rate cuts will come so it’s probably wise to start thinking about the logistics of stepping out sooner rather than later. Too much of a delay could mean such high rates are no longer available.