- Era of zero interest rates and free money is well and truly over
- Central bank interest rates influence the return available from lower-risk asset classes such as cash and bonds
- Ten-year government gilt is seen as the risk-free rate and any other investment should return more than that to compensate for the additional risks
- The higher the gilt yield goes, the less inclined or obliged investors will feel to take risk and pay up for other asset classes, such as shares (and vice-versa), so rates affect the ‘P’ in the P/E (price to earnings ratio)
- The cost of money also affects activity in the real economy – and therefore corporate earnings, or the ‘E’ in the P/E ratio
“Central banks on both sides of the Atlantic are still talking a tough game on interest rates and they are still running Quantitative Tightening (QT) programmes, with the result that stock and bond markets are having to listen, whether they like it or not,” says AJ Bell investment director Russ Mould. “Promises that interest rates will stay higher for longer mean the yield on government bonds is shooting higher in response and that is putting pressure on share prices, not least because investors can grab a higher yield on certain UK gilts or US Treasuries than they can from headline share indices and do less, in theory, for less risk.
Source: Refinitiv data
“Central banks are still grappling with inflation and trying to get it back to their 2% targets. Higher interest rates and QT are designed to both cool the economy (so inflation does not take a hold) and dampen down animal spirits in financial markets, so money is not allocated badly, excess risk is not taken, and dangerous accidents that could have a reflexive impact upon the ‘real economy’ do not happen.
“Reaching that 2% inflation target may not be easy. Fifteen years of ultra-loose unorthodox monetary policy in the form of zero interest rate policies (ZIRP) and Quantitative Easing (QE), with a good dollop of fiscal stimulus during Covid and lockdowns on top, could well take some reversing. In addition, central banks will not want to squeeze their economy so hard that it tips into recession, because the huge increase in debt since 2007 means that servicing those additional borrowings would be all the harder if government tax income drops, unemployment rises and corporate profit falls. A deflationary spiral would be ruinous.
“For the moment, though, inflation (or perhaps stagflation) is seen as the bigger threat than deflation, at least judging by central bank rhetoric and bond market action. Central bankers are threatening to keep rates higher for longer in their drive to rein in inflation, and bond yields are responding accordingly. If returns on cash stay higher for longer, the coupons on newly issued bonds or yields on existing ones will have to rise to compete and attract buyers of the paper.
“Another explanation for the bond market blitz is soaring government debt and interest bills. The UK’s government debt has surged past the £2.5 trillion mark, and the Office for Budget Responsibility reckons the annual interest bill will be £115 billion – the only government department that will cost more is the NHS.
Source: Refinitiv data
“In the USA, another flap over the debt ceiling is a reminder that America has added over $1.5 trillion in government borrowing since April’s debt deal on Capitol Hill, and that the interest bill on the $33 trillion federal debt mountain is now running at an annualised rate just shy of $1 trillion.
Source: FRED – St. Louis Federal Reserve database
“And this is when the US and UK economies are thought to be doing well and unemployment is low. What would happen if the economy were to tip into recession? Borrowing would surely spike higher. That would mean more gilts and Treasuries for sale and that in turn might mean higher coupons will be needed to tempt buyers.
“Either way, the 4.60% yield on UK ten-year gilts means the yield is now higher than a year ago, at the height of the panic inspired by Trussonomics, and back to levels not seen since late 2007.
“The 4.80% yield on the US ten-year Treasury is the highest since summer 2007, just before the Great Financial Crisis hit home.
“Go further back, and these yields are actually pretty normal. It is only the last fifteen years that have been the aberration, even if for many investors they began to feel like a ‘new normal’.
“But if bond markets are going back to normal, does this mean the last fifteen years have been an aberration for share prices, cryptocurrencies, non-fungible tokens and other asset classes too? After all, many asset classes have thrived during an era of ultra-cheap money and the party has been huge.
“Perhaps the hangover is now on its way, not least because the return available on cash, and by extension the risk-free rate available on government benchmark bonds, sets the reference point by which the attractiveness or otherwise of all asset classes will be judged.”
From TINA to TIARA
“For much of the past decade, bullish investors have argued that share prices should rise because record-low interest rates and record low government bond yields, thanks to Quantitative Easing, means that ‘There Is No Alternative,’ or TINA. To try and get any sort of return on their cash they had to look to different, riskier assets.
“The test now is whether higher returns on cash and higher government bond yields tempt them to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly. Some strategists are now saying that TIARA is the order of the day – ‘There Is A Real Alternative’ to equities, in the form of cash and bonds, now that returns on them are more competitive.
“Note how higher interest rates – and government bond yields – are taking their toll on so-called ‘bond proxy’ sectors such as utilities. Utilities do not grow their earnings quickly, as demand is fairly stable, and returns are regulated. As a result, their shares tend to offer plump yields to attract buyers and compensate them for the risks involved with holding the paper. But higher government bond yields may mean bond proxies look less attractive, on a relative basis, as government paper should offer less risk than shares in a company (there is much less chance of default than there is a dividend cut).
Source: Refinitiv data
Source: Refinitiv data
“However, inflation must remain a consideration here, as it still outstrips returns on cash and bond yields in the UK, while tales of investors ‘going to cash’ are misleading. If someone sells a share, someone still must buy it and hand over their cash in exchange. The shares do not disappear, so there is no wholesale movement from one asset class to the next. Instead, there is a relative movement in intent and desire, as reflected in the higher or lower returns that the investor is prepared to accept in return for exposure to that asset class, be it cash, bonds, shares or something else.
“This also helps to explain why the debate over when central banks will pause or pivot on their interest rate increases, and Quantitative Tightening policies is so important. The thinking is clearly that share prices will start to surge once there is any hint of rate cuts or a return to Quantitative Easing, while a period of higher rates than expected for longer than expected, should inflation prove sticky, could well have the opposite effect and drive share prices lower.”
The risk-free rate
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because, in principle, the government will not default on its liabilities. It will always be good to make the interest payments (or coupons) on time and return the initial investment (or principal) once the bond matures, even if it must print money to do so.
“Bear in mind that the yield on the bond will differ from the coupon or interest rate at its time of issue. This is because the bond’s price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss after the purchase of the bond, since it will usually be redeemed upon maturity at its issue price.
“The last time the UK defaulted was 1672 and the Stop of Exchequer under King Charles II and as such as the ten-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“At the time of writing, the ten-year gilt is yielding 4.60%. This is therefore the minimum nominal annual return on any investment that any investor should accept, since it is seen as risk-free (despite the tiny chance the UK does default, or the other challenges posed by movements in interest rates and inflation).
“Any other alternative investment carries more risk so the investor should demand more from them:
- Investment-grade corporate bonds should yield more than government bonds because companies can and do go bust and management teams can do silly things
- High-yield (or junk) corporate bonds should yield more than investment grade bonds because these firms are more indebted, and the risk of bankruptcy and default is higher
- Shares should offer the prospect of higher total returns than junk debt because share prices go down as well as up, while a junk bond will offer pre-determined interest payments and return of the initial investment if all goes well
“The returns demanded by an investor to compensate themselves for the additional risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates.
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly issued gilts, which will have to come with a higher yield to attract buyers and help the government fund its spending needs.
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase. This means a higher yield on newly issued bonds or paying a lower price for existing bonds (as a lower price means a higher yield for bonds, just as it does for shares).
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and also perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth. In its simplest form, this can be seen in the price/earnings (PE) ratio. Earnings will go up or down depending upon the business cycle and the company’s target industry and acumen. The price, or multiple, paid can be affected by many things, including the company’s finances, managerial competence and governance, as well as the predictability and reliability of its operations and financial performance.
“Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis. As a result, they may decide to pay lower prices and multiples – a lower P for the E – and that is why stock markets can slide as rates rise, especially because someone still has to hold the shares. They do not just disappear, so the new owner has to make a judgement on what they are worth.
“For property, the same calculation will apply – the rental yield will be benchmarked against the safer options, in nominal terms at least, of cash and gilts and other bonds. New buildings will need to offer a higher rental yield to attract buyers, and that often means lower property values.”
The discount rate
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“Such a valuation approach is not necessarily suitable for, or at least easy to apply to, all companies, as some have business models and revenue and cash flow streams that are very volatile, or at least cyclical.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“There are many moving parts to a DCF, including assumptions about the long-term operating margin, capital investment requirements and terminal growth rate of a business, while a further key input is the assumed cost of the company’s funding (be it debt or equity) and the discount rate. The discount rate is used to value the future cash flows in today’s money by discounting back those expected cash flows at a given rate.
“The greater the uncertainty over the value of the forecasts, the higher the discount rate and the higher interest rates and gilt yields go then the higher the discount rate will go too.
“And the higher the discount rate, the less the future cash flows will be worth in today’s money. That means a lower valuation for the equity and a lower theoretical share price, although the opposite holds true, too – the lower the discount rate, the higher the equity value and the higher the theoretical share price.
“This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade (and especially in 2020 to 2021). The problem now for holders of this sort of company is that the opposite effect is kicking in, at least for now, judging by how America’s tech-laden NASDAQ is down 10% from its July peak.”
Source: Refinitiv data
