Investors are refusing to accept that higher interest rates are here to stay – and that’s a problem for financial markets

Traders work on the floor of the New York Stock Exchange in New York August 10.Seth Little/The Associated Press

As interest rates soar, the driving force that has dictated decision-making in the financial markets for the last fifteen years is dying. In the blink of an eye, disoriented investors were exposed to a new world, a world that has dramatically different expectations of a decent return.

Despite everything that has changed, it can be difficult to accept that the era of ever-lower interest rates is truly over. Deep down there may be a tacit admission of shifting winds, but it is often coupled with a denial of what it all means.

The hope, it seems, is that the damage has already been done. Tech stocks were flattened and Canadian home prices finally started falling. But the maelstrom of rising interest rates is hard to stem, and for that reason it’s likely to sweep through financial markets, hitting everything from private equity to blue-chip stocks.

Such a sea change can be elusive. Since the global financial crisis of 2008/09, investors of all stripes have become accustomed to ever falling interest rates. By July 2020, the yield on the 10-year US Treasury bond, a benchmark for financial markets, had fallen to a meager 0.52 percent.

The trend was so absurd, such a departure from historical norms, that it even spawned a new mantra: “Longer Lower.” Investors learned to accept that interest rates would stay low longer than once imagined – long enough for it to become the norm.

And now, in just seven months, everything has changed after searing inflation and geopolitical earthquakes forced a paradigm shift. In July, the Bank of Canada raised interest rates by a full percentage point, not since 1998. The Federal Reserve raised its own by 0.75 percentage point a few weeks later.

The reaction has been pretty bizarre ever since. For example, the Nasdaq Composite Index, a barometer of growth stocks, is up 23 percent from its June low. Investors seem to think the worst is behind us and are glad things are back to the way they were.

The Reality: There is a high probability that there is no going back, at least not for a long time.

“Many economists, strategists and investors believe the world hasn’t changed — that we’re in a normal cycle,” said Tom Galvin, chief investment officer at City National Rochdale, a subsidiary of the Royal Bank of Canada of about 50 US -Dollar. billions in assets under management. He disagrees. “We are in a new era.”

This summer, Mr. Galvin published a paper setting out all of this and explaining why the new mantra must be “higher, longer”.

“Inflation will be higher for longer than we expected, interest rates will be higher for longer, geopolitical tensions and uncertainty will be higher for longer, and high volatility in the economy and financial markets will be higher for longer,” he wrote.

Of course, Mr. Galvin is only one voice, and everything in business and finance is so messy right now that it’s almost impossible to say anything with 100 percent certainty. In Canada, inflation is at its highest level in almost 40 years, but unemployment is at a record low. I don’t want that to happen.

But in the past two weeks, a spate of Federal Reserve officials have given public interviews saying the same thing.

The day after stock markets rallied this week on news that US inflation was flat month-on-month in July, Mary Daly, president of the San Francisco branch of the Federal Reserve, told the Financial Times that investors shouldn’t so dizzy. While the data was encouraging, core prices, a basket that excludes volatile items like energy costs, still rose. “That’s why we don’t want to declare victory over the fall in inflation,” she said. “We’re far from done.”

Diane Swonk, chief economist at KPMG, can’t quite understand why investors are forgetting what scares the Fed most: inflation. One of the central bank’s greatest omissions over the last 50 years was that by the 1970s, US inflation had spiraled out of control – or, in economics jargon, “got stuck” – forcing the Fed to take drastic measures to to reconcile them.

“This is a Fed that remembers the 1970s,” Ms. Swonk said. “Most people who are involved in the financial markets don’t do that.” Especially not the 20- and 30-year-old retailers who sent stock markets soaring in 2021.

Fed officials can’t say outright that they will tolerate a recession in exchange for curbing inflation, but the 1980s are proof that they did and will. “They will raise rates and hold for a while to curb inflation,” predicts Ms. Swonk.

Despite the history, there is still speculation in certain corners of the financial markets that the Fed will change course. And there’s some recent precedent for that. Twice in the last decade, the Fed and Bank of Canada signaled they were ready to take action to cool the economy, but on both occasions central banks ultimately backed down. They did so first in 2013 after bond investors freaked out, and then again in 2019.

The big difference between now and then is inflation. Even Mike Novogratz, one of the most popular investors in cryptocurrencies, the mother of all speculative assets, warned earlier this spring that interest rates are not going to fall anytime soon. “No cavalry is coming to push a V-shaped recovery,” he wrote in a letter to investors after the crypto market collapse, citing the rapid rebound in stock markets after the initial outbreak of the pandemic. “The Fed can’t ‘bail out’ the market until inflation falls.”

It’s difficult to predict exactly how higher interest rates will affect financial markets, but like underperforming tech stocks, the asset classes that have benefited most from the low-interest-rate environment are the most vulnerable to shocks. Private equity and private credit, to name just two, top the list.

When debt was ultra-cheap, private equity funds could finance their acquisitions for next to nothing. At the same time, passive investing gained momentum, taking the shine off hedge funds and mutual funds. Private equity then became a vehicle for outsized returns.

Earlier this year, Harvard Business School professor Victoria Ivashina wrote a paper predicting a market shock in the industry and arguing that tailwinds are gone. “As private equity cash flow stabilizes and industry growth slows, the fee structure will shrink and compensation will shift to be more performance-related,” she wrote.

There are already signs that large investors are turning their backs on private equity. Earlier this month, John Graham, chief executive of the Canada Pension Plan Investment Board, one of the world’s largest institutional investors, announced that CPPIB sees more value in public markets than private markets for now. And in a July report, Jefferies, an investment bank, said big money managers, including pension funds and sovereign wealth funds, sold the most shares in buyout and venture capital funds, worth $33 billion on record, during the first half of the year.

Private debt funds, which lend money to higher-risk borrowers, are also vulnerable in the current environment. Money has flowed into the sector over the last five years because these investment vehicles typically pay yields of 8%, but that yield is looking a lot less rosy now, with one-year guaranteed investment certificates yielding nearly 4.5%.

These asset classes are by no means dead in the water. The same goes for stocks and so many others. Interest rates have skyrocketed, and fast, but they’re still low by historical standards.

However, there are many reasons why investors of all persuasions should no longer expect a quick return to the downside. The latest inflation data is encouraging, but it is a single data point. Who knows what kind of energy crisis Europe and Britain will face this winter and what impact that will have on oil and gas prices.

Inflation is also not known to disappear quickly. “It’s easy to go from 6 percent core inflation to 4 percent,” said economist Ms Swonk. “It’s really hard to go from 4 percent to 2 percent.”

Your time is valuable. Have the Top Business Headlines Newsletter conveniently delivered to your inbox in the morning or evening. Sign up today.