Interest rate dangers – Investors’ Chronicle

Next year will see rising interest rates. Futures markets are pricing in a full percentage point rise in UK bank rate and a 0.6 per cent rise in the US fed funds rate. Of course, expectations of rising rates have been wrong before and might be again. But this poses the question: if these expectations are correct, what would it mean for equities?

Common sense says: nothing. Everybody has suspected for months that rates will rise and so if anything is ever going to be in the price, it is this fact. What’s more a time of rising interest rates (assuming they happen) will be a time of increased confidence about the world economy: central banks would not raise rates if it were otherwise. Such confidence should support equities, mitigating any concern about the impact of higher rates in dampening demand.

Statistical evidence corroborates this common sense. Between 1985 and 2009 (a time when interest rates were moving up and down) the correlation between annual changes in bank rate and in the All-share index was a statistically insignificant 0.14.

Equities, then, have nothing to fear from rising rates.

Not so fast. It’s not unknown for widely-anticipated rate rises to hurt shares. They – and especially emerging markets – sold off in 1994-95 as the Fed raised rates.

This could happen again.

For one thing, it’s possible that equities have in recent years been supported by a “reach for yield”: despair at nugatory returns on cash have tempted some investors to hold more equities than they ordinarily would. As rates rise, this reach for yield could go into reverse and cause a sell-off in equities.

Sadly, however, it’s hard to tell whether there really has been such a reach for yield: our motives for holding shares are always many and various. There is experimental evidence here, but it is mixed. Harvard University’s Carmen Wang has found that in experimental markets reductions in expected returns on cash and equities do cause people to shift their wealth into the latter. But on the other hand, experiments at the University of Muenster find that this only happens when interest rates are negative.

A further danger has been described in a recent paper by Princeton University’s Atif Mian and colleagues. They show that falling rates in the US have disproportionately benefited larger companies, because they have enjoyed the biggest falls in the cost and availability of capital, thus enabling them to expand faster. It might be no accident, therefore, that the S&P 500 has trended strongly upwards since the 1990s while bond yields have trended down. This poses the danger that if rates start rising, they would suffer more than others. The upshot could be a drop in the valuations of the big tech companies that have raised the S&P so much in recent years, which would drag down the whole index.

You might reply that rate rises will be small. Certainly, the Fed and Bank of England are likely to accompany any moves with assurances that further rises will be small and gradual. But herein lies a further risk – that of extrapolative expectations: rising rates might trigger expectations of further rises.

Also, asset prices are determined not only by our central expectation of what will happen but rather by the probability-weighted average of all possible scenarios: shares fall if investors perceive an increased risk of recession even if they think that risk remains small. As rates rise, investors might attach greater probability to high-rate scenarios even if their central expectation is for rates to stay low – which would be especially likely if inflation looks like exceeding expectations. This would be bad for equities, especially those sensitive to interest rates.

There are, therefore, dangers for equities in rising rates. But why aren’t they already discounted?

To see the answer, let’s suppose you agree with this. Would you switch into cash now?

Not necessarily. Doing so could mean missing out on weeks of out-performance by equities over cash – which, if you are a professional fund manager, means the stigma of underperforming your rivals. Maynard Keynes said that the object of investing was to “beat the gun”, but the point is to beat it by only a short time rather than by months. Which means rate rises might not be discounted already.

How great are these dangers? The truth is, nobody knows. Share prices are determined not by reality, nor even by opinion, but by opinions about opinions, and maybe higher derivatives thereof. And these can change suddenly, which is why prices are more volatile than economic reality.

A further complication is the simple fact that rising rates would be so unusual. We’ve not seen a serious sustained period of rises since at least the mid-00s, which means almost nobody under the age of 35 has professional experience of rising rates. A whole generation faces a new adventure – and we can’t be sure how they’ll respond.

So yes, rising rates are a possible danger to equities not because of the damage they’ll do to output and demand – which should be small – but because of the nature of market psychology. The fact we cannot quantify this danger does not mean it Is non-existent.

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