A time of transitions

Springtime in the south looms, while in the north autumn approaches. Of course, the weather cares little for human-made calendars, and cold or heat might linger too long or come too early, depending on where you are and what your preference is. But ultimately, the seasons do change. This is a time of transitions.

The big transition on global markets is the turning point in global interest rates after a period where they were at elevated levels across most economies (China and Japan being notable exceptions).

When interest rates rise, a few things happen. The cost of servicing existing debt often rises, reducing disposable income for households and margins for companies. The cost of new borrowing or rolling over existing debt rises, potentially discouraging the purchases of homes, cars and capital equipment. It raises the hurdle for the expected return any new investment must generate before being considered profitable and worthwhile. These effects slow economic growth, though they are somewhat offset by the fact that savers now earn higher returns on their cash. Slower growth in turn weighs on company profits, and therefore the bond and share prices of these firms should adjust to reflect the new reality. Since all asset classes compete for capital with one another, high interest rates make cash and cash-like investments more attractive. Bond, real estate and equity valuations tend to adjust lower to reflect the relative loss of attractiveness. Finally, since not all countries raise interest rates at the same time and at the same pace, the gap between countries’ interest rates shift, resulting in exchange rate movements. Money tends to flow to where risk-adjusted returns are highest, weakening the ‘sending’ currency and strengthening the ’receiving’ currency.

Most of these things happened with the 2021 to 2023 global surge in interest rates. The notable exception is that we did not see much of the first item on the list in the US since most mortgages have fixed interest rates these days. Most homeowners did not experience rising interest burdens, but it also meant few were prepared to sell their homes and lose their low mortgage rates. This blunted the impact of the rate hikes, and the US economy remained resilient, but also effectively froze the housing market. There were other factors behind the resilience, including fiscal stimulus and a surge in immigrants which boosted the labour force and kept wage increases under control. Nonetheless, there are parts of the US economy facing the squeeze from higher interest rates and that will benefit from relief, including lower income consumers, small business, and homebuilders. The same goes for other countries where central banks have already cut rates, and in places like South Africa where the Reserve Bank is likely to do so soon.

As interest rates start falling, the effects listed above should start reversing. The impact on markets is perhaps most pronounced and, since markets tend to price in the future before it happens, most immediate. We’ve therefore seen a rally in interest-rate sensitive assets of all stripes across the globe, as well as currency moves. Let’s look at a few of these in turn.

Dropping dollar
The US had a stronger recovery from Covid than other major economies, and therefore its central bank, the Fed, could hike interest rates to higher levels to combat inflation than some of its peers.

The result was a jump in the US dollar against the euro, the yen, the yuan and others, including the rand. The dollar has probably also benefited from its traditional role as a haven amid rolling geopolitical crises.

A strong dollar is rarely good for the rest of the world and is probably not very good for the US economy either. A strong dollar means that servicing the trillions in dollar denominated debt owed by governments and companies outside the US becomes more expensive. It tends to put upward pressure on inflation and interest rates in vulnerable countries, and it throws sand in the gears of global commerce since most trade is still invoiced and settled in dollars.

The past few weeks have seen the trade-weighted dollar index losing ground, however, as shown in chart 1. The index is back to early 2022 levels, reversing most of the gains it made when US interest rates started rising. Seen in a bigger perspective, it still looks quite strong, , trading above its long-term average of 97. There is probably room for further declines, but it will depend on how the growth and interest rate outlook of the US evolves compared to those of its major trading partners.

Chart 1: US dollar index

Source: LSEG Datastream

Bonds rallied (meaning yields fell) in the first few days of August as US growth fears resurfaced and equity markets slumped. Bonds performed their traditional role as a portfolio diversifier, something that was possible because yields are at respectably high levels today, unlike in 2022, when bonds and equities crashed simultaneously. While equities have recovered, bond yields have not, pointing to the deeper rate cuts now priced in. The benchmark US 10-year Treasury yield fell from 4% to 3.9% during the month, while the two-year yield also fell to 3.9%, ending the 25-month inversion of the yield curve, one of the longest stretches ever.

Global bond indices have not yet recouped the 2022 losses, except for high yield corporate bonds. But for new investors that is not a bad thing, and most South African investors only started paying attention to global bonds after the sell-off, i.e. after yields had risen.

Real estate endured a torrid time when rates rose, since it is by nature a leveraged business. Coming soon after Covid-related disruptions to property use patters, notably the office sector, the sentiment shock was pronounced. As chart 2 shows, global listed property (the FTSE EPRA/NAREIT Developed Index) fell more than bonds and equities when the Fed started hiking rates in 2022. With a cutting cycle now coming into view, the sector gained 12% in July and August, but this has not put it back to pre-2022 levels yet.

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