High interest rates are here to stay – and the markets have woken up


Guardians of monetary probity are dropping cheap money one by one, either by choice or because a falling currency forces their hand. Very soon the aberration of negative interest rates will be for the history books and normal service will have resumed.

There will be a cost to borrowing money and if you are lucky enough to have some to lend, you will be rewarded for it. It’s a better place for us, but going back there after 15 years in the mirror world of free money is going to be painful.

Hope is eternal for investors, especially in the stock market where the default is to look for the bright side. But even for stock market investors, the penny is falling. The next year is going to be tough for businesses and investors during a time of deliberate demand destruction and rising costs.

Somewhat belatedly, stock buyers are catching up with the bond market where people are temperamentally more inclined to see the cloud wrap around that silver lining.

One of the notable features of the post-financial crisis era, and a key driver of the long bull market in equities, has been central banks’ maintenance of negative real yields.

Keeping bond yields below the expected rate of inflation was explicitly designed to induce investors to shift to riskier assets in search of acceptable returns. If you were losing money in inflation-adjusted terms by holding cash or bonds, it made sense to move your money into stocks.

Real yields fell deep into negative territory during the pandemic as inflation expectations rose while central banks kept interest rates, and therefore bond yields, artificially low. In the past few months, two things have happened to radically reverse this situation.

First, as we know and confirmed by this week’s announcements, central banks have relearned their primary focus. Second, inflation expectations have started to fall as investors realize what this policy change means – recession may not be the desired outcome, but it will be acceptable to independent central banks if it is what it takes to reverse inflation.

With inflation still in high single digits on both sides of the Atlantic, it may seem unlikely that inflation will return to central bank targets, but that is what financial futures markets imply.

A measure of what investors expect from inflation 10 years from now, derived from the difference in yield between inflation-linked bonds and nominal bonds, has fallen in just five months from 3% to 2.4%. Investors are beginning to believe central banks at the word.

At the same time, investors now expect this week’s interest rate hikes to continue for the foreseeable future. By next spring, US interest rates are expected to reach 4.6%. Bond yields now reflect this reality, with income from bonds maturing in two years now exceeding 4%.

Far from keeping bond yields well below the expected rate of inflation, they are now well above it. The pressure is real in every sense of the word.


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