THINKING ABOUT HIGH INTEREST RATES

by: Issues: May / June 2004. Tags: Strategy. Categories: Strategy.

With practically zero-cost money, there’s only one way for interest rates to go. This regulator contributor knows what a manger must feel like – and should consider doing.

Interest rates are extraordinarily low. Executives should pay heed. Interest rates are a crucial consideration in many important business decisions. It is a good time for executives to be positioning their enterprises for a period of rising, and possibly quite unstable, interest rates. The positioning options are not all that many or novel, but they are worth having on the front burner.

Interest rates affect enterprises in many ways. They play a big role in determining overall business conditions-rising (falling) interest rates often lead to economic slowdown (expansion). Executives continually must choose among debt and equity financing options-the lower (higher) interest rates, the more (less) attractive debt. The decision to invest in the likes of plant, equipment, machinery, systems, long-term training, research and development is one of the most important, yet most perilous, that executives face-the lower (higher) interest rates, the better (worse) the economics of new investment. The value of our currency against other currencies, especially the U.S. dollar, is a major determinant of success for exporting companies-the lower (higher) our interest rates, the weaker (stronger) the Canadian dollar. Executives usually have a keen corporate interest in the stock market-the lower (higher) interest rates, the more upward (downward) pressure on the price of stocks. Inflation affects wage settlements, product pricing and supplier contracts-the lower (higher) interest rates, the more likely inflation will rise (fall).

People talk about interest rates as if they were talking about a single thing. The reality is there are as many interest rates as there are debt financial instruments, and debt financial instruments cover a waterfront of maturities and assorted other features like collateral, convertibility, retractability, extendibility and callability. That said, interest rates are very low just about across the board and by any standard.

Short-maturity (under one year) interest rates are spectacular. A few examples make the point: the U.S. federal funds rate, 1.00%; the European Central Bank refinancing rate, 2.00%; the Bank of Japan overnight call rate, 0.00% (that is not a misprint); the Bank of Canada overnight rate, 2.00%. These are all officially administered rates. The picture is similar across treasury bills, bankers’ acceptances, commercial paper and assorted short-term derivative rates. Japan’s three-month money market rate is .02% (that is three one-hundredths of 1%). Amazing! For some historical perspective, consider that the last time the U.S. federal funds rate hit 1.00% was 1958 and Dwight Eisenhower was in the White House; John Diefenbaker was Prime Minister of Canada in 1960 when the Bank of Canada overnight rate was last 2.00%; European Central Bank interest rates are at a record low. Whatever else, this is not a business-as-usual interest rate environment!

Longer (over five years) interest rates are also low, but not as extreme. U.S. and Canada long bonds are in 5% territory, with Europe a little lower. The yield curve is a plot of interest rates against maturity for government securities. The Japanese yield curve is one for the record books with zero at the short end, about .15% at the two year point and 1.50% at the long end. That the Japanese economy has been struggling for so long with slow-growth deflation with interest rates so low says about all that needs to be said about Japanese business conditions. Longer-term corporate interest rates fall in above government debt. Interest rates on high-risk bonds have come down relative to government bonds, a situation that bears watching.

The case for rising interest rates sometime in the not too distant future is compelling. It is not compelling enough, however, for me to provide any guarantees. If you make any investment or financing decisions based on my view, you are on your own. But by all means, good luck!

First, interest rates, like so many economic variables including real growth and the unemployment rate, ride cycles over time around long-term average values. In the down part of cycles, natural forces push values up, and vice versa in the up part of cycles. Interest rates are clearly in the extreme lower range of their cycle, and the longer they stay there, the more likely they are to rise. It is called “reversion to the mean” and it works, though timing is hard to predict. If you think of long-term inflation-adjusted interest rates averaging around 3% (a kind of natural rate of interest), then interest rates surely do have some rising “reversion to the mean” ahead of them. Treasury bill rates in the 2% ballpark in a 2% inflation world equals zero adjusted for inflation; that is a long way from 3%.

Second, economists have long believed that the expected rate of inflation was a key component of interest rates. If I am going to lend you my money, the interest rate I charge will at minimum have to cover the change in price level expected over the term of the loan; otherwise, I will lose purchasing power. Put another way, when you pay me back, I want the money to buy what it bought when I lent you the money in the first place.

Inflation is very low right now, but there are a number of things lurking that have the potential to push inflation up materially; if that happens, it is likely that interest rates will rise accordingly. Pressures on inflation include a strong global and U.S. economy and a not-too-bad Canadian economy, considerable upward pressure on commodity prices and an enormous amount of monetary expansion that has not been fully absorbed in consumer and producer prices. The latter is particularly worrisome. In an effort to head off deflationary recession, central banks including the Bank of Canada and the Federal Reserve injected staggering liquidity into their financial systems. Printing money on the scale that occurred inevitably ends up in prices; the only question is when; it is a short step from there to rising interest rates. It should also be noted that in the face of rising inflation, central banks usually push up interest rates on their own to contain the situation. Early signs of emerging inflation are starting to show up in the ongoing economic data.

Third, and related to the previous point, monetary conditions in Canada and the U.S. at some point will have to tighten from their astonishing ease of the past number of years. Just returning to neutral monetary conditions is likely to put upward pressure on interest rates. Interest rates tend to fall (rise) with the extent of monetary ease (tightening).

Fourth, Canadian interest rates usually follow U.S. interest rates. Our financial markets are not an island but rather a quite small boat in a big financial sea. Our interest rates move with the flow and the flow is likely to be up. The U.S. federal funds rate is 1.00%; U.S. monetary policy has been incredibly easy; where else can U.S. interest rates go but up? With the U.S. 10 times the size of our economy and exports to the U.S. one-third of our economy, where their economy and interest rates go is where our economy and interest rates go.

Fifth, as credit demand increases (decreases), there is upward (downward) pressure on interest rates. The economy is strengthening because consumer, household, business and government spending is rising; a healthy part of the increase must be financed; the greater the financing need, the more likely interest rates will rise. Of course, rising savings supply could offset rising credit demand and keep interest rates flat, but with our tendency to spend most of what we take in, we should not look for much interest rate help from the rising savings side.

It is not as if there are not some pressures pushing interest rates down, but in my view they will not carry the day. At the head of the list is the desire to promote Canadian exports to the U.S. by keeping the Canadian dollar down against the U.S. dollar; low interest rates reduce the attractiveness of Canadian dollar investing. An abrupt deterioration in the economy or a major drop in the inflation rate from here would also take the upward pressure off interest rates.

The case for unstable interest rates is even more compelling than the case for rising interest rates. First, huge financial imbalances such as the U.S. current account deficit and the U.S. federal government spending deficit are destabilizing influences on everybody’s interest rates and exchange rates. Second, consumer, household, business and government debt levels are arguably unprecedented; the greater the debt, the greater the risk; the greater the risk, the more unpredictable the interest rate outlook. Third, the economy looks to me like it will continue to strengthen, but who can argue that conditions are not precarious; the greater the economic uncertainty, the greater the interest rate uncertainty. Fourth, out of the blue, China is now the world’s second-largest economy on a purchasing power parity basis; China’s economic power combined with its greatly undervalued currency and relative inexperience as a global economic player are not a plus for interest rate stability. Fifth, the U.S. dollar has declined considerably against a number of world currencies, especially the euro, but probably has a good distance still to fall; until the U.S. dollar stabilizes, interest rates are going to be volatile. Sixth, the outlook for inflation is anything but a certainty, and inflation uncertainty can magnify itself in interest rate uncertainty. Seventh, the stock market is in very volatile territory, and where stock market volatility goes, interest rate volatility is usually not far behind. Finally, turning points heighten volatility; most indications suggest we are at or near a turning point in the interest rate cycle.

Where interest rates are headed is really anyone’s guess. My guess is up, with increasing volatility, but what will be will be. In the face of such an environment, executives should consider a number of steps.

  • Quantitatively determine just how exposed your enterprise is to interest rate levels and volatility. I would be surprised if many enterprises did not find that they were more exposed than they thought. Only by quantifying exposure will enterprises know how seriously they should take the interest rate outlook.
  • Put resources into forecasting interest rates consistent with the exposure. Interest rates are not perfectly predictable whatever resources are put into the effort, but by the same token, rising resources properly targeted can significantly improve performance.
  • Look at enterprise debt structure to see where locking-in funds for the long term at fixed interest rates might have merit. Also, look at the short-term debt/long-term debt/equity balance in light of possible interest rate scenarios.
  • Consider how derivative strategies involving futures, options and swaps can be used to hedge against untoward interest rate movements.
  • The greater the debt on the books, the greater the interest rate exposure. Look at options that minimize debt.
  • If bonds are an important component of pension and other corporate portfolios, consider lightening up on the grounds that when interest rates rise, bond prices fall.

It is the rare enterprise that is not in one way or another seriously impacted by the course of interest rates. Now seems a particularly good time for executives to contemplate their interest rate situation. Executives should assure they are prepared for rising and volatile interest rates.