The government yield curve impacts discount rates used across almost all financial assets. Discounting using ultra-low interest rates helps to rationalise high equity multiples today. When viewed from the perspective of traditional standalone valuation metrics, equities appear to be somewhere between marginally and eye-wateringly expensive. However, when set alongside exceptionally low bond yields, the real yield available on equities could be sorely tempting for a long-term investor.
From that perspective, asset valuations rest on the precarious ledge of low real and nominal yields and we should be wary of any developments that put low interest rates at risk. There are severe potential consequences for broader financial stability if monetary stimulus is withdrawn in a clumsy or haphazard fashion. In our multi-asset portfolios, that means we are constantly on the lookout for cheap ways to protect against policy mistakes and rising yields.
More theoretically, low interest rates have been a great enabler. Those who studied Economics 101 (or equivalent) will have been taught about the 'crowding out' effect whereby increasing debt drives up interest rates which in turn suppresses investment spending. In this case, the usual gap between the classroom and the real world is a yawning gulf. Despite the secular rise in private and public sector debt burdens since the early 1980s, the debt service ratio (i.e. the amount of income necessary to cover debt repayments) has collapsed as interest rates have tumbled. As shown in the chart below, gross interest payments of the household, non-financial business and government sectors have halved despite a doubling in debt levels.
High debt levels increase the sensitivity to either rising rates or deteriorating income. The curse of low interest rates is therefore that they incentivise changes in economic structures (e.g. higher debt) which, in turn, make low interest rates more entrenched. This dynamic is especially troubling for those with long duration liabilities who suffer when interest rates stay low.
You can see a different form of the 'blessing' vs. 'curse' debate playing out at the Federal Reserve. Some policymakers (e.g. Bill Dudley, President of the New York Fed) argue that low interest rates represent a loosening in financial conditions and should accelerate the pace of future rate hikes; others (e.g. Charles Evans, President of the Chicago Fed) argue that low interest rates are symptomatic of a weak growth environment and should decelerate the pace of rate hikes.
Perhaps the clearest message from low interest rates is that they have become a necessary, but not sufficient, condition for continued economic expansion. Over the last 70 years, the average real interest rate has been around 200bp below GDP growth in the US (and around 150bp in the UK).
For sure, it is still hard to rationalise the recent deeply negative real interest rates as being 'normal'. But with trend growth of below 2% today due to the downshift in demographics, it is equally hard to see why we should expect real interest rates to trade meaningfully above zero. This structural pressure gives us confidence that any significant back-up in yields is likely to be short-lived.
The blessing and curse of low interest rates is therefore that they are (probably) here to stay. In all likelihood, they have become a near-permanent feature of the investment landscape rather than a short-term aberration that will be swiftly forgotten.