The new era of rising interest rates

For Low Risk investors, it’s the best of times and the worst of times. 

Interest rates are up. A lot. And they’ve risen fast. Like, really fast. I haven’t seen anything like this in my lifetime. 

This is causing a lot of market volatility. But if you step back to look at the big picture, you’ll realize this is great news for savers. It means that you don’t have to take unreasonable risks in order to earn a reasonable return on your investment portfolio.

But it’s bad news for people, companies, and governments in debt. If you’re borrowing on a floating rate basis, you’re already feeling the pain. If your borrowing rate is fixed, the pain will come at renewal time. 

My somewhat contrarian take on all of this is that it is a good thing. Interest rates are the single most important price in the free market: the price of money. A dollar today should be worth more than a dollar at some point in the future. This is just common sense, but at the peak of the collective insanity gripping bond market participants, over 40% of government debt outstanding had a negative interest rate! Yes, that means we were paying governments for the privilege of lending them money. 

Of course, this was horrible for savers. This led investors into riskier and riskier portfolios to replace the income they would have traditionally received from the safety of government bonds. 

A much broader impact - one that will impact all of us for generations to come - is that governments lost all fiscal discipline. And why wouldn’t they? They could borrow vast sums without consequence. The emergency pandemic measures added to the already-smoking tinderbox, but politicians and central banks operated under the belief that low rates would be with us forever. 

There’s a great snippet of a Justin Trudeau press conference in June of 2020, where our Prime Minister answered a reporter who had the temerity to ask about the cost to service hundreds of billions of dollars of new debt. “Interest rates are at historic lows, Glen,” he explained. “Because of historically low interest rates, the debt servicing costs will be low.” 

Duh, Glen. What a dumb question. 

This same exercise was repeated around the world, from politicians on both the left and the right. Because with interest rates effectively pinned to zero, it would have been irrational for politicians not to have taken on debt. Their job was to get us across the chasm of uncertainty, and to secure their re-election at the same time (more the latter than the former, but who’s keeping score?) If they could do so at minimal cost, why wouldn’t they?

Except rates are no longer low. In fact, they are far higher than they were just 12 months ago. And we are facing a new era where markets will enforce fiscal discipline on profligate governments. Just ask new UK Prime Minister Liz Truss and her chancellor Kwasi Kwarteng, who had to walk back tax cuts and a huge projected deficit when bond market participants dumped gilts and pounds, putting tremendous strain on UK pension funds. 

In 1994, political strategist James Carville famously said “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” And this is what he was talking about. The so-called “bond vigilantes” are back for real, and for the first time since the 1990’s. 

We are moving to a future where money is no longer free, and that has all sorts of implications for governments, families, and investors. 

It means higher debt servicing costs, and will require more spending discipline. 

It means that investments that don’t promise a high probability of success will be sold, and that money will flow to projects promising more reliable returns. 

It means that high risk gets sold, and low risk gets bought.

These are the times when a conservative investment approach keeps you on track.