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In March 2022, the Central Bank of the US (the Federal Reserve or the Fed) started raising overnight interest rates from near 0 to 5%+ in less than a year and a half, in an unprecedented move to battle the high inflation and inflation expectations.
Suddenly, wealth holders sitting on idle cash that yielded little return started making 5% returns on the same. This has had a strong impact on any investment market, whether real estate, bonds, or equities. Essentially, everything else became less attractive in a higher interest rate environment vis a vis cash, in addition to lending rates, such as mortgage rates increasing above rental yields.
As you can see from the chart and as we have discussed before, the rate hike regime has perhaps been declared as finished, and now a new one is dawning.
The economics behind the interest rate hike
The Fed needs to balance two critical essential elements:
- Keeping a steady inflation somewhere around 2%
- Maintaining a healthy economy: keeping unemployment down
So let’s start with some key factors of why the Fed increased interest rates so dramatically to begin with and what are the data points showing that this policy will now reverse over the coming year(s).
Inflation
The spike of inflation and the fear of further inflationary forces drove the hike in interest rates over that period. The chart below shows the preceding spike and then the eventual cooling and inflation stabilization. With the inflation rate now normalized and inflation expectations as well normalized, this battle can be declared won:
However, why would that lead to the Fed changing course rather than keeping things the way they are now?
That brings us to their second motivation, which is to make sure they maintain a healthy US economy.
Unemployment and Economic Growth
For the past few years, many talks have been about recession risk considering the spike in interest rates. Raising interest rates so aggressively usually would lead to an economic slowdown, which has yet to be the case. To make these decisions, the Fed looks at multiple data sources; however, a very important one is job openings in the US.
As you can see, there is now a downward trend in job openings, and multiple other data sources show a similar story of a cooling economy.
This has led to the belief that the Fed will soon change policy.
Interest Rate Predictions
Global capital holders and investors have predicted with their own capital that over the next year, interest rates will go down at least a full percentage point from where they are today, considering the trends being observed. However, what does that mean to wealth holders?
A few things:
1—If you are holding cash and benefiting from the high interest rate environment, most likely, you are to benefit less from the return you are earning.
2—If you are holding bonds (or Sukuk), you most likely got disadvantaged in your portfolio as interest rates shot up. However, these fixed-income instruments would become more attractive in a world where cash is yielding less return.
3—If you are holding equities, note that the companies you own, you are likely to pay less interest on their debt capital, and your future stream of earnings also becomes more attractive in a lesser interest rate environment.
This really means that when interest rates go down, mostly everything else that has future earnings (bonds, real estate, and equities) becomes more attractive due to cash being less attractive and lending rates going down.
Those who wait for interest rates to go down before investing in other asset classes will realize that by then, the investment market will have already gone up as investors take action before the event happens to take advantage of being the first to take action.
Summary
Interest rates are comparatively very high at the moment, which is very attractive for anyone holding cash and taking advantage of the environment. However, that is most likely not due to last; therefore, the best investors align their portfolios with their long-term objectives. Rarely do you see affluent and wealthy individuals plan on consuming most of their wealth in the short term. Wealth is most often held for long-term goals such as securing financial independence or enjoying a retirement income stream for very long periods of time. Therefore, our view is to align your portfolio with these objectives and have the majority of your wealth in owning as much future diversified earnings as possible through investing in diversified equities or to fix your lending return over a longer duration through bonds (or Sukuk) to have more certainty over your longer-term returns.
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