The Interest Rate Bubble

David Long
October 8, 2020

Five years ago, I fixed my mortgage at an interest rate of around 2.5%. At that time, I thought this was extraordinary and an opportunity I was unlikely to see again. I remember being very frustrated that I could not arrange a 10-year fix.

Thank goodness I couldn’t, as I have just re-fixed my mortgage for the next 5 years for a little over 1.25%.

To put this into perspective, when we bought our first house, a 5-year fixed rate was in the region of 8.5%. Of course, as interest rates have fallen, house prices have risen as illustrated below.

The problem for anyone starting out on the housing ladder today is not therefore the cost of borrowing, but the rise in house prices which have increased by almost 450% since the late 90’s. The great worry is what happens when, or if, the great bull cycle in interest rates starts to reverse. Will homeowners face the prospect of falling house prices and at the same time borrowing costs increase?

Investors and savers face a similar challenge. Falling interest rates have propelled asset prices higher, while the expected return on those investments has fallen. Traditional safe haven investments, such as UK government bonds, yield almost nothing. You will receive a paltry 0.25% a year for the privilege of lending your hard-earned savings to the government for 10 years. This is actually lower than the rate of inflation, so your investment is almost guaranteed to lose value. What’s more, there is a very real risk that inflation may increase over the next 10 years to offset the vast quantities of quantitative easing (money printing) that governments and central banks have now come to rely on.

If you want to hedge the risk of inflation, you can do so by buying index linked Gilts, but to do so, you must accept a negative yield of -2.9%, which even when you add back the inflation element, still gives you a negative real yield of over -1% per annum.

In practical terms, this means that you will never be able to save sufficiently during your working life to be able to generate a reasonable pension income from government bonds. It is an extraordinary sign of the times that many investors are still prepared to lend to the government on these terms, knowing that they will lose value in real terms, but preferring this to the risk that asset prices may fall during that time.

Defined benefit pension schemes face a particularly challenging set of circumstances, as they have a known set of future pension liabilities to pay, which increase as yields fall. To hedge against this interest rate risk, actuaries and indeed regulation have made such schemes to effectively become forced buyers of Gilts, regardless of the fact that such investments provide no real return to their members. This, in turn, has pushed Gilt yields lower, necessitating greater purchases of yet more Gilts – a vicious cycle that has played out now for over 20 years.

But how long can this carry on before the interest rate bubble bursts and what options do long term investors have if it does?

If Japan is any guide, then the interest rate bubble could continue for a very long time. Japanese government bond yields fell below 2% in the mid 1990’s and have never exceeded this level since. In fact, Japanese government bond yields have hovered around zero or negative for the past 5 years, so there is no reason to assume that UK interest rates will rise quickly or indeed anytime soon.

In the near term, the repercussions of the COVID-19 pandemic and the resulting lockdown, mean a demand deficit is likely to remain in the UK for some time. This suggests that we have little to immediately fear from inflation, as interest rates will need to remain low to stimulate the economy. The longer-term outlook, however, is far from clear. The response to COVID-19 has also pushed government debt to a record £2 trillion, 500% higher than at the turn of the millennium and breaching 100% of GDP for the first time since 1963. This level of debt is not sustainable and is certainly not consistent with negative real yields. The most likely way in which this imbalance will correct itself is through a pickup in inflation over the medium term, steadily eroding the value of all that debt, which in turn will push up yields and interest rates.

In such an environment, traditional safe haven investments such as government bonds or cash may prove themselves to be anything but safe. Instead, savers and investors will need to find investments that are able to maintain their real value in the face of rising inflation. Real assets such as Gold have been a particular favourite of the market in recent times, with the price exceeding $2,000 an ounce in August. Gold is indeed a good hedge against inflation, but the metal itself has little practical value and must simply be stored at not inconsiderable cost. The cost of ownership is dependent on interest rates, and Gold prices have typically demonstrated inverse correlation to US interest rates. If those rates are expected to rise, then Gold’s allure may quickly fade.

Other real assets such as land and commodities should fare better, as limited supply together with critical utility value enable these assets to at least keep pace with inflation. But it is equities that perhaps offer the best value to long-term investors. Not just any equities but crucially companies that are innovating and using technology in all its forms to increase productivity, as has been demonstrated by the extraordinary rise in a relatively small number of mega-tech companies.

Rising productivity is the best antidote to the challenges of the next decade. This will not come from the bureaucracy of central government or from monetary policy or from the weight of ever more regulation. Productivity arises from human ingenuity and an environment that enables a degree of controlled risk taking.

Throughout history, it is free-markets and companies in particular that have consistently proven themselves to be crucibles of innovation and progress.

For investors, safe havens are likely to be hard to find over the next decade, but investment returns are likely still to be found in those companies that are dynamic enough to respond to the changing environment and innovative enough to challenge the status quo.