Interest rates: are investors in for a nasty shock?

Inflation is dead, it seems. The consensus view is that interest rates will only rise slowly from here and peak at a much lower level than in past economic cycles. In truth, however, forecasts are often wrong and the underlying drivers of much more rapid inflation are there, even if they are currently quiescent.

4 January 2016

As US interest rates go up after an almost unprecedented seven years of no change, the consensus is that further increases from here will be slow and low. Most commentators believe that any sharp hike would snuff out a global economy still only slowly stuttering into life after the credit crunch. But history tells us that forecasts have a habit of not turning out quite as planned. 

We have looked back at a wide range of periods when rates have risen much faster than expected. Often these periods have been associated with a sharp uptick in inflation or a sudden currency collapse. While neither looks likely today, the seeds are there, given the way that central banks have dealt with the aftermath of the collapse in the debt bubble. Quantitative easing (QE) has massively raised the potential stock of money around the globe, while divergent interest rate policies are putting currencies at risk. The possibility of a signifi cant rise in rates, though not central to our forecasts, therefore deserves consideration. It is a tail risk that some investors may want to be prepared for. 

The drivers of higher rates: inflation and capital flight

Historically, two major factors have led to a rapid and significant increase in interest rates. 

The first is accelerating price inflation. In extreme cases, hyperinflation is caused by large government deficits being financed by the printing of money rather than through taxation or borrowing. With a rapid increase in the quantity of money in circulation, not supported by a corresponding growth in output, an imbalance between the demand and supply of money is created which causes rapid inflation.

Periods of high inflation can also be caused by extreme supply shocks, like the oil crises of the 1970s which then triggered a wage-price spiral. This was particularly evident amongst the incidents of sharply rising interest rates we looked at in developed markets. Figure 1 shows some of the most aggressive hiking cycles (allowing two rate rises per country). Most of these rate increases occurred between the mid-1970s and late 1980s. This was a period of high inflation triggered by the 1973 oil shock and intensified by the subsequent energy crisis in 1979. Most of the rate hikes shown were to try and curb high inflation rates, but led most developed countries into recession at the turn of the 1980s.

The second case which has historically led to rapid rate hikes is a sudden fall in a country’s exchange rate. The typical situation involves a country with a chronic balance of payments deficit and a fixed exchange rate. Speculators may believe that the central bank does not have enough reserves to defend the fixed exchange rate and therefore they sell the currency, forcing the country to devalue and move to a floating exchange rate. Demand and supply shocks can lead to this sort of crisis as investors question the solvency and creditworthiness of issuers of securities, triggering a flight of capital out of the country.

Fixed exchange rates are less common than they were, but a country with one such rate that is causing concern right now is China. Indeed, the global stock market wobbles in the summer of 2015 followed a devaluation of the renminbi by the Chinese authorities following large outflows of capital as investors became nervous about the country’s massive debts.

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