Finally, we can catch a breath on high interest rates in developed economies with the U.S. Fed laying the groundwork for its interest rate cut cycle in September. At the end of September, the U.S. Fed cut its benchmark rate by 50bps to 5.00% following other major central banks like the BoC (75 bps cut to 4.25%), BoE (25 bps cut to 5.00%), ECB (85 bps to 3.65%), PBoC (10 bps cut to 3.35%). The only exception is Japan, where interest rate has risen from -0.10% to 0.25%, fostering the Yen carry trade which disrupted the global financial market momentarily. With the dovish interest rate environment, it is important to review a few developments which are likely to evolve in the near term. However, these expected developments may not evolve like the pre-pandemic era considering that the pandemic has created a few structural adjustments in the global economy, which may not turn around in the near term.
Perhaps the most obvious impact as we transition back to low interest rate is on economic growth. The interest rate hike cycle, which commenced in 2021, clearly hurt economic growth as central bankers tilted their policy focus to reducing inflation. Lower interest rate will reduce overall borrowing cost as most costs of loans are pegged to the benchmark interest rate. The lower interest rate will increase business investment, which enhances labour productivity and output. It is also expected to spur consumer spending, which is a major driver of economic activity in developed economies. This impact, however, means potential inflationary pressure, especially in countries where potential GDP is low. Potential inflationary pressures are downside risks to economic growth as it prompts the ‘brows’ of central bankers. Therefore, the growth impact will be unevenly distributed across the different developed markets with countries having their low interest rate coinciding with higher household savings, rising business investment and improved labour productivity and a moderate labour force growth keeping up with overall cost of living, benefitting more than their peers.
There is also the developed-emerging market wedge which is expected to resurface in the near term. Bond investors will ‘prey’ on yield arbitrage as they move their capital to emerging markets offering higher yields on their bonds. This could boost asset prices and lead to stronger currencies in emerging economies. The note of caution, however, is that emerging economies without stable currencies, strong credit ratings and solid economic outlook may not realize this gain. Relatively speaking, this means the U.S. Dollar is expected to depreciate. The duo of a weaker dollar and lower interest rate means cheaper financing cost of bond issuances for emerging economies. This improves overall debt sustainability and fiscal stability for emerging economies, particularly those with substantial foreign-denominated debt. It should be noted that emerging economies could backpedal if the increased capital flows to emerging markets increases domestic demand and inflation causing elevated inflation rates to persist.
Moving on to the global financial market, a dispensation of low interest rate will make equities relatively attractive than bonds. With low interest rates, equity valuations rise, meaning that share prices appreciate especially for stocks with high earnings growth (usually these are stocks of companies in sectors like technology, consumer discretionary, and green energy). Emerging bond yields are expected to also fall as higher demand for them raises their prices and crash their yields. Investors’ risk appetite is expected to inch higher since bonds in developed markets, which are considered safer instruments, offer lower yield. Investors will likely turn to riskier instruments like high-yield bonds, equities, and even cryptocurrencies to position their liquidity. Consequently, the demand for global risk-hedging commodities, especially gold, is likely to grow.
Lower interest rate environment is expected to foster housing affordability for new mortgages and existing variable-rate mortgages which are up for renewal. However, this impact depends on the context of the country’s housing market that is considered. Countries with burgeoning demand, without the prospect of ‘capping’ the growth in housing demand in the near term, may not realize this gain. Furthermore, the low interest rate will spur housing demand, which could raise the price of housing, offsetting the positive impact from lower mortgage rates. The net impact will likely be worse off for economies where there is a shortage of housing supply.
From a policy point of view, central bankers will be unable to bolster economic growth once interest rates hit their ‘neutral’ levels. In most developed economies, the neutral rate of interest is 2%. If the economies of developed economies fail to grow as expected when interest rates are falling, their central banks ‘hands’ become tied in terms of stoking economic growth. The alternative route will be fiscal policies. When the low interest rate persists for a long time, governments may become more inclined to use fiscal policy (such as increased government spending) to boost economic activity since the overall cost of government borrowing is now cheaper.
As far as banks are concerned, lower interest rate means narrower interest margins as they initiate new loans at lower interest rates and also generate low yield on their fixed income investments especially those from quantitative tightening. To maintain profitability, banks and financial institutions may seek higher-risk investments, which could lead to more aggressive lending or greater exposure to riskier asset classes.
The impact of low interest rates on consumer and corporate debt is mixed. Corporate organizations are able to issue new bonds and refinance existing ones at lower yields. Therefore, we expect a record growth in corporate bond issuances. On the flip side, lower interest rate will likely grow the loan book of most households especially in countries where there is multifarious access to cheap credit. As household debts build up, the default risk rises and this means higher provisioning by banks, which eats into their profit. Therefore, financial stress is a linked prospect related to low interest rates.
In summary, the expected impact of falling interest rates in developed economies is generally positive for economic growth, financial markets, and emerging markets in the short term. However, the longer-term implications could include risks related to financial stability, debt levels, and inflation.
Written by Michael Ogunremi
