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Gradually rising interest rates? Don’t be too sure

An analysis of the last 700 years of financial history suggests it would be dangerous for investors to be too confident they know how interest rates are going to behave over the coming years

28/03/2018

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Last week, under new boss Jerome Powell, the Federal Reserve voted to raise US interest rates by a quarter of a percentage point.

Two months earlier, under outgoing chair Janet Yellen, the US central bank kept rates steady.

At first glance, then, these were two very different rate-setting meetings and yet the two statements issued immediately after each had a great deal in common.

In both, for example, the Fed’s rate-setting committee said it expected that “with further gradual adjustments in the stance of monetary policy”, economic activity would “expand at a moderate pace in the medium term and labour market conditions would remain strong”.

The committee also said it expected economic conditions would “evolve in a manner that will warrant further gradual increases”.

That word “gradual” has also cropped up in the context of interest rates on this side of the Atlantic, with Bank of England governor Mark Carney using it more than once towards the end of last year as he sought to manage market expectations on future rate hikes.

All in all, then that’s pretty reassuring, isn’t it? The powers that be have a plan and, even if UK and US rates are on the up, it is all going to happen, well, gradually.

Interest rates 'lower for longer'? 

As we have discussed before, here on The Value Perspective, the link between interest rates and company share prices may not be obvious but it certainly exists, with the historic low rates of recent years helping to push markets to a succession of new highs.

All things considered then, the wider market seems happy enough to go along with the idea interest rates are going to remain ‘lower for longer’.

Not ‘lower for ever’ of course but while, for example, UK rates may be ticking upwards, investors might still feel able to take comfort from the fact they have some way to go before they reach the 5% or so that was seen as the norm in the two decades before the 2008/09 financial crisis.

Investors might feel less reassured, however, if they read a blog that ran on the Bank of England’s Bank Underground site at the end of last year.

Written by Harvard-based historian Paul Schmelzing, Renaissance roots and rapid reversals offers a long-term (a very long-term) take on global interest rates.

Using data going back seven centuries, no less, he argues anyone clinging to a “secular stagnation” narrative – that “markets are trapped in a period of permanently lower equilibrium real rates” – might want to think again.

Think again

Regular visitors to The Value Perspective will know our strongly-held view that the future is uncertain and so Schmelzing’s blog certainly strikes a chord.

He has analysed global interest rates going all the way back to 1311 and found evidence that suggests the decline in real interest rates seen since the 1980s fits into a pattern of a much deeper trend stretching back five centuries.

By Schmelzing’s calculations, there have been eight previous “real rate depressions”, where interest rates have fallen for a prolonged period of time.

Now pushing 35 years, he notes, the one we are now living through – with rates in most major economies around the world at or near all-time lows, compared with an average of 2.6% over the last 200 years and 4.78% overall – is the second longest such period on record. 

Schmelzing’s most striking conclusion, however, is that every time the world emerges from one of these interest rate depressions, the turnarounds have typically been “both quick and sizable”.

“Most reversals to ‘real rate stagnation’ periods have been rapid, non-linear and took place on average after 26 years,” he continues.

“Within 24 months after hitting their troughs in the rate depression cycle, rates gained on average 315 basis points [3.15%], with two reversals showing real rate appreciations of more than 600 basis points [6%] within two years.”

Ultimately, no one knows what will happen

 None of which is to say this will happen this time – only that it would be dangerous for investors to be too confident they know how interest rates are going to behave in the future.

As we wrote in The link between rates and share prices, here on The Value Perspective, we believe only a couple of things can be said on the subject with any confidence:

  • A market that has become used to low rates is likely to have some adjustments to make; and
  • In the process of making those adjustments, the market is likely to overreact in some areas, creating opportunities for stockpicking investors.

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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