Interest rate cycles and their
impact on asset returns

Interest rates profoundly affect world economies and our personal finances. Monthly mortgage payments, for many their largest single financial commitment, are dependent on either short-term interest rates, set by central banks, or government bond yields (or in bond jargon ‘swap’ rates, which are closely linked to government bond yields). The recent rise in interest rates has been painful for most mortgage holders. Conversely, savers who for many years had to suffer very low nominal interest rates, below the rate of inflation, now clearly benefit from higher nominal rates and positive real returns.

The financial health of nations is affected by interest rates. In recent years most countries have funded significant budget deficits by issuing government debt, like US Treasuries or UK Gilts. The cost of servicing this debt has increased materially as interest rates have risen, placing a greater burden on government expenditure.

The level of interest rates is impacted my many things. Short term rates can generally be controlled by central banks but longer-term rates, such as 30-year bond yields, are determined by market forces. A dramatic example of market forces was seen in the UK in September 2022 after the infamous Truss budget. Long dated index linked Gilts fell in value by over 50% in the space of three days1.

Maintaining ‘price stability’, namely low and stable inflation, is a key objective of central banks and their main tool for achieving this is via interest rates. The enormous bond buying programmes by the Federal Reserve, European Central Bank and the Bank of England, among many other monetary authorities, pushed yields lower by bidding up the prices on their bonds. For many years this appeared to be a win-win situation as low interest rates and large-scale bond purchase programmes, funded by newly created electronic money, didn’t appear to cause inflation.

From 2009 until 2022 most countries set interest rates at extraordinarily low levels; in the case of Japan and many European countries rates were negative, allowing governments to borrow for free - effectively being paid to borrow money! This seems inconsistent with economic laws, which require that the ‘time value of money’ should be positive. For readers interested in this I would highly recommend the book ‘The Price of Time’ by Edward Chancellor.

While there were arguably some positive economic effects from the ultra-low interest regimes, namely, helping governments, corporations and individuals with low debt service costs, importantly, including mortgages, there were also some longer-term negative consequences. Low interest rates almost certainly inflated house prices and other assets creating complex issues such as generational inequality, which enhanced aggravated wealth inequality in societies. Low yields on long bonds also created funding gaps for many of the UK’s defined benefit pension schemes, which could potentially have long standing repercussions on the individual schemes and society.

The Covid pandemic and geopolitical troubles caused an unexpected rise in inflation which necessitated abrupt rises in interest rates. This lead to the worst year on record for bond investors in 2022. However, since then inflation has fallen sharply which has allowed central banks to start cutting rates. We are therefore at a turning point in the rate cycle, with major central banks including the European Central Bank and the Bank of Canada having cut interest rates, while the UK and US will surely follow soon.

We have analysed returns for different asset classes before and after the start of an interest rate easing cycle. [EP1] [EK2] The good news is that historically, based on many previous interest rate cycles, government bonds, investment grade corporate bonds and equities tend to perform well while other asset classes have underperformed2. It must be remembered that all interest rate cycles are different, and history is notoriously unreliable in financial forecasting! Notwithstanding, there are good grounds for optimism in the outlook for equities and high-grade fixed income asset classes over the coming year as interest rates move lower.

Sources: 1Bloomberg L.P., September 2022. 2Bloomberg L.P., twenty-year history to Dec 2023, data since 1974.