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RE-PRICING THE COST OF MONEY

For years after the financial crisis of 2007-08, the world’s central banks, led by the US Federal Reserve, pursued highly accommodative policies featuring “quantitative easing” and ultra-low (or negative) official interest rates. Having seen the beginnings of the process of normalising rates in the US during Janet Yellen’s time at the Fed, the COVID19 pandemic sent central banks back into crisis and rescue mode once again. Central bank balance sheets across the globe ballooned and interest rates were slashed, with short term official rates cut to zero or negative. Once again, the amount of bonds trading with a negative yield to maturity, soared to record levels.


Added to all this, governments, particularly the US government, boosted fiscal spending hugely in order to support individuals and industries who had suffered enormously in the face of economic lockdowns. The US government literally posted cheques to its citizens (many of whom had no real need for them as they continued to be able to work from home). Nonetheless the view was that support for the economy now would turn out to be less expensive than allowing businesses to fail and then have to stimulate an economy which had suffered severe “scarring”.


By the beginning of 2021 however, things had changed somewhat. COVID cases had fallen, vaccines were beginning to be rolled out and both business and consumer confidence indicators were rising. Newlyelected President Joe Biden was inaugurated and entered office with a commitment to support “hard working American families” and defeat the virus. Along with his newly appointed Treasury Secretary, the aforementioned Janet Yellen, the President set about passing another USD 1.9 trillion “relief bill”, posting millions more stimulus cheques to US voters and spending billions on everything from airlines to vaccination distribution. The key thinking behind all this spending and the continued monetary stimulus is that it is necessary to “go big or go home”. Both Janet Yellen and the current Fed Chair, Jerome Powell argue that one of the lessons from the 2008 crisis was that it was a mistake to withdraw stimulus too early.


Thus, when, following the Fed’s February meeting Chairman Powell stressed that the Fed would not raise rates for the foreseeable future, investors began to price in the impact of an economic recovery and further massive stimulus combined with enormous amounts of monetary liquidity. Initially this took the form of rising inflation expectations and then, following a messy 7 year auction, bond investors began to demand higher rates, particularly for longer maturities. As a result, the yield on the benchmark 10-year Treasury rose quickly from 0.9% at the end of 2020 to 1.7% by the end of March. The yield on longer-dated (e.g 30 year) paper rose more quickly resulting in a steepening of the yield curve to levels not seen since the early days of the Trump administration. It feels like this has been a pivotal period. US ten-year bonds matter because they are in effect the reference interest rate for the world. Though it is likely that they will consolidate for a while in the 1.60-1.75% range, it looks like they are now on an upward trajectory. We have been saying for some time that we felt that by the end of 2021, they could reach 2% or even a bit higher and nothing so far has changed that view. Of course, interest rates at these levels are still historically low and in many ways it would be a healthy thing if across the wider world rates would rise back to more normal (or at least positive) levels.


Higher yields and steeper yield curves help banks to maintain attractive lending margins and so place less pressure on them to undertake riskier lending activities. They also benefit savers both personal and institutional (e.g insurance companies). On the other hand, they undermine the valuation of a number of “pre-profit” high tech companies (eg many electric vehicle stocks) and they really hurt people who are sitting on too much leverage, particularly where it is combined with high operating leverage. Often, these situations aren’t easy to spot.


A return to a more normal level of interest rates is broadly something we would welcome. However, given that it makes money more expensive for some people who can’t really afford it, being on the lookout for pockets of excess leverage will be an important activity for many investors this year

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