What does higher for longer mean?
Over the past year, various central bankers including Reserve Bank of India governor Shaktikanta Das and US Federal Reserve chairman Jerome Powell have said that tackling high inflation may need interest rates being kept higher for longer. Financial markets, however, had predicted that central banks would start cutting rates by the end of 2022, less than a year after the hiking cycle commenced. Indeed, data shows that the Fed started cutting rates only eight months after its previous hiking cycle ended in December 2018. The RBI, which ended its last hiking cycle in August 2018, started reducing rates six months later.
Why would interest rates remain high?
Central banks control inflation by hiking rates, making it costlier to access capital and thereby curbing demand in the economy. For most of the 21st century, inflation was absent from advanced economies. However, during the Covid crisis, governments and central banks slashed interest rates and pumped in huge amounts of money to revive their economies. As activity resumed and pent-up demand burst out, the excess money caused the classical inflation outcome of ‘too much money chasing too few goods’. Global supply chains, already disrupted by the pandemic, saw further ruptures with the Ukraine-Russia war. Consequently, inflation has stubbornly refused to return to official targets.
What happens to financial markets?Financial markets, which include bonds, stocks, currencies, derivatives, and commodities, are impacted by interest rate changes. Given that higher interest rates dampen economic growth prospects, the outlook for corporate earnings weakens, hurting stock prices. Further, with higher policy rates pushing up government bond yields, or the ‘risk-free’ rate of borrowing in the economy, stock market valuations undergo corrections. Emerging market currencies weaken when the US hikes rates as global funds exit other countries and rush towards the higher returns in the world’s largest economy. Gold prices often decline, as the precious metal, which is considered a safe investment, does not provide returns.What does it mean for stocks?
Stock markets benefit when central banks pump in funds into the economy and cut rates as companies find it cheaper to access money and expand business operations. Lower cost of funds boosts profitability and leads to earnings being revised higher, driving up stock prices. Tellingly, Indian and US stock markets notched up record gains in 2020, with the rally extending into the next year. The abrupt change in central bank policy since 2022, led to the opposite phenomenon, with US stock indices seeing their worst decline since the Global Financial Crisis of 2008. Several startups wound up operations as higher cost of funds led to a financing crunch.
What happens to bonds?
Bond prices fall and yields rise when interest rates are raised. Given that most bonds are fixed-income instruments—implying a fixed return—investors demand a higher return or yield to purchase fresh bonds in a high inflation environment. When the central bank raises interest rates to tackle inflation, the cost of funds in the banking system goes up and in turn, investors seek a higher yield from the bonds that they purchase. Higher government bond yields lead to a rise in borrowing costs across the economy as companies must pay more than the sovereign does to raise funds through bonds.
Where do currencies go?
When the Federal Reserve hikes interest rates, the US dollar strengthens as investors across the world prefer to take out funds from elsewhere and park them in the global economic superpower. While the US dollar strengthens against the majority of global currencies, emerging market currencies, such as the Indian rupee, typically suffer the most. This is because foreign investors who had earlier favoured the relatively higher returns of emerging markets abruptly exit those economies. For countries with large import dependency, such as India, a depreciating currency adds to inflation pressures as commodities such as crude oil are dollar-denominated.
