Collective wisdom at the moment seems to be that Interest Rates are due to start rising soon from their current, historically unprecedented, extreme low levels - Central Banks around the world have been pursuing ZIRP - Zero Interest Rate Policy (not actually zero but very close).
In the UK, we are in a similar situation - QE is finished now I believe (I might be wrong on this) and it appears that Interest Rates are going to rise - but again I feel this will be a paltry Token Gesture and we are getting near the Window to the General Election in May 2015 within which the BOE cannot raise interest rates for political reasons. In other words, if the BOE is to raise rates, it must happen within the next few months - I would guess this is more and more unlikely and it would only be a tiny tweak anyway.
In the Eurozone there is no chance of a rate cut - the region is in a miserable condition and Mario Draghi will not tighten Monetary Policy when the area is in this state. There is more chance of Monetary Policy effectively being loosened by a QE programme - but will the Germans let him do this? Even if Draghi can pull it off, we may be a long way off and it is vital to realise that maybe it will take a Crisis (tanking stock markets whatever happens) to persuade the Germans to agree (big Rally once they do !!).
Japanese rates will stay low as this is consistent with the Abe Government’s ‘3 arrows’ policy to reflate the stagnant economy.
Don’t ask me about China - I think Economists and other ‘experts’ trying to judge the Chinese economy using Western Economic thinking are making a huge cognitive error - things are very different to anything we have seen before (oh god, did I just say “this time it’s different” !! ).
Why do Central Banks change Interest Rates?
The point of Interest Rate rises or falls driven by Central Banks is to attempt to control the level of Inflation within an economy. Modern economic thinking is that high inflation (I guess 6% plus) and Deflation (prices falling, i.e. inflation below zero) are to be avoided. I think the BOE (Bank of England) target rate over the Medium Term is 2% - i.e. a bit of Inflation but not too much (Goldilocks Economy - Not too hot, Not too cold - think Porridge…yum).
Inflation essentially has 2 component drivers - ‘Cost Push’ which arises from commodity prices and stuff (think Oil going up in price) and ‘Demand Pull’ which is a situation where demand rises hugely and fast and supply is unable to respond in time - prices naturally will rise.
You can think of Demand Pull Inflation for an individual product - Houses are a great example - there is limited supply and it takes time to build a house (also hindered by restrictive planning laws and NIMBYs - Not in My Back Yard), but Demand can spike very fast - usually as a result of daft government policy. Demand Pull can also be considered in aggregate for the whole economy - i.e. the level of general demand for Goods and Services in the economy exceeds the level of supply - this can cause higher inflation.
The reason I am making this distinction is to help you understand why Central Banks may not need to rush to try to raise Interest Rates to damp down Inflation. I am sure many people think Inflation is currently quite high as they see the cost of their grocery shopping and utility bills rising and the Media in general love the scare story that Inflation is rampant - fuelled of course by Mr Milliband’s so called ‘Cost of Living Crisis’.
In reality, most of this perceived Inflation comes from Cost Push. The key thing to understand is that the BOE can do virtually nothing about Cost Push Inflation by raising Interest Rates - although higher rates will probably mean a higher Pound Sterling which might ease Cost Push Inflation from imported items to an extent. Recent big falls in Oil Prices have a very deflationary impact and help Central Banks hugely - in that they can delay raising rates.
There are also a couple more reasons why Central Banks, particularly in the UK, are highly motivated to keep Interest Rates low for as long as they can get away with it - and they are notoriously ‘behind the curve’ and slow at raising rates long after they should have done and also lowering rates too late when tough times hit.
Firstly, governments in general have built up huge piles of Debt and are still running Deficits to keep the show on the road. Deficits are the excess of overspending a government does which is above its annual tax receipts - the Debt is the cumulative total of these Deficits. A rise in Interest Rates would cause the proportion of government spending on Debt Interest Payments to rise - this would mean even more pressure on other government departments and further Austerity measures - arguably (by Left thinking politicians and sympathisers mostly) a self-defeating undertaking.
In addition, particularly in the UK, mortgage rates would rise if central banks raise Interest Rates within their control (I worded it this way as there are other ‘interest rates‘ in the economy that Central Banks have less control over - but these are subjects for a future Blog !!). It does appear that many people have very big mortgages after the binges leading up to the Credit Crunch in 2008 and are only just clinging on - even a small rise in Interest Rates in the UK could tip them over the edge.
Central Banks know this and are under considerable pressure to prevent this happening - it could be catastrophic for Western Economies. This is less of a problem for the US as their Mortgages have fixed interest rates for fixed terms - and their houses are much cheaper so less debt anyway.
So, in summary, I am of the belief that Central Banks cannot do a lot about Inflation at the moment and I expect a very slow process of raising Interest Rates and it will be over many years.
What does this mean for Stocks?
To illustrate this more precisely and it’s impact on Stocks, I would suggest that Interest Rates will probably still be around 2% to 2.5% at the absolute maximum by the end of 2015 even if the UK’s recovery continues - and I am probably overestimating there as well. I would guess that historically low interest rates are here to stay globally for a long, long time.
Anyway, should we care? From what I can tell from various things I have read, it seems that Equities can actually do ok in an environment of steadily rising Interest Rates as such a Monetary Policy stance usually accompanies general economic recovery - which is good for company profits and by extension, share prices. I understand it is only when rates hit 5% to 6% that stocks may start to suffer. Chris Dillow in Investors Chronicle has written about this a few times.
You might argue that this is a very optimistic (glass half full) outlook. However, my counter to this is that being optimistic with regards to the stockmarket is actually a very good philosophy and is borne out by the facts. No one would argue that the stockmarket has not done well pretty much since the dawn of time with the FTSE100 rising something like 7% a year since WW2.
So, apart from brief, dramatic periods where it would have paid to be a pessimist, on the whole having a negative outlook will have cost you money. Just think about all those constant stories you read (particularly from MoneyWeek) about how the UK is doomed and Oil will run out and Global Warming will drown us all etc. It is all terrible information for you to bet your cash on - you would have missed out on a massive Bull Market in stocks for the last 5 years if you listened to this scaremongering. Be warned.