Despite the sharp rise in interest rates worldwide, the economy is proving to be relatively stable. However, experts warn that this could be deceptive. After all, monetary policy takes effect with some delay. What does this mean for the various asset classes?

"By the time central banks have done their job, policy rates will have risen decently," says Chris Iggo, CIO Core Investments at AXA Investment Managers. He summarizes the impact for individual asset classes. In the U.S., for example, he sees signs of lower credit volume growth and a weaker housing market - and at some point, debt servicing will also become more expensive, he is convinced. How bad it gets, he says, depends mainly on inflation and the response of the U.S. central bank, the Fed. The markets would be happy to see any sign, however small, that interest rate hikes are coming to an end. But if that fails to materialize, corporate bond and stock prices will hardly seem reasonable, he warns, especially since further interest rate steps are likely to follow.

Interest rates could rise further

In the meantime, the Fed had raised its key interest rate by 450 basis points, and according to the futures market, another 75 basis points would follow (as of March 8, 2023). In fact, the Fed announced at the end of March that it would raise the key interest rate by another 25 basis points. Iggo cites the portal Bankrate.com, which writes that the average 30-year mortgage rate has risen from 3% at the end of 2021 to 7% now. The interest rate on 90-day non-financial commercial paper - a proxy for the short-term rate relevant to businesses - has risen more than 450 basis points in just over a year, it said. "So anyone borrowing in the U.S. today has to pay much higher interest rates, and they could go up even more," Iggo said.

However, with its last rate hike, the Fed also communicated that "some additional policy firming may be appropriate," i.e., further tightening of interest rates may be necessary. This is a change in the Fed's verbal communication, which previously always emphasized that "ongoing increases in the target range will be appropriate," i.e., increases would be necessary. Iggo stresses that tightening monetary policy too much could trigger a recession, as higher borrowing costs would eventually weaken demand. The situation is no different in the euro area and the UK.

Some investment experts, for example from Columbia Threadneedle Investments (see our blog from 'Datum'), were still communicating recently: "We don't expect the European Central Bank to raise interest rates as much as the market expects, and stock prices still have upside potential." However, the ECB raised the key interest rate again in mid-March by 50 basis points to 3.5%. Further increases are likely to follow.

Credit demand weakens

No one knows exactly how long the delay is before monetary policy takes effect, Iggo says. But often it would take a long time. Based on past experience, it would not be unusual if most of it still came. Already, he says, there are signs that higher interest rates are working. According to the Fed, mortgage demand had fallen dramatically, with fewer real estate lenders recently reporting high demand than at any time since the international financial crisis. Banks had also tightened their lending terms, for businesses and households alike. Nearly half of all institutions would report tighter lending standards, as well as a widening gap between lending and refinancing rates and significantly lower demand for commercial and industrial loans. "The credit crunch has begun, and it's likely to get worse," Iggo says.

Real estate hits hard

"The higher interest rates are discouraging borrowers," Iggo is convinced. Investment and consumption would slow. Mortgage demand and construction activity would fall. Currently, 30% fewer building permits would be issued than at the peak in late 2021. Less would be built; residential investment would decline, as would construction employment and demand for construction-related durable goods. It was not a catastrophe, however; compared to previous periods of weakness, the downturn appeared mild: from 2005 to 2009, the number of building permits fell by a remarkable 78%, and in the late 1980s, it was 55%. Still, higher interest rates were not without consequences for the housing market, Iggo warns. Home prices also gradually declined.

Are credits safe?

Iggo points to the incipient doubts about credits. The spreads do not really reflect the economic risks so far - probably also because the consequences of higher interest rates are only beginning to be felt. For some companies, however, rising borrowing costs are a problem, he said. "If more bonds are then downgraded and, in the high-yield area, default risks also increase, spreads widen and corporate bonds are in the red," he explains. Currently, the spread duration of the U.S. corporate bond index is just under seven years. If spreads widened by 100 basis points, prices would fall by 7%. In the event of a downturn, a further widening is conceivable.

Corporate bond issuers must offer more

Borrowing costs are rising slowly: The average weighted coupon of U.S. investment-grade stocks rose last year, but only slightly, Iggo knows. According to the ICE Bank of America US Corporate Index (excluding banks), it is currently 3.85% (as of March 8, 2023), down from a low of 3.65% at the end of last year. On the eve of the pandemic, it had been 4%. In Europe, after years of extremely low interest rates for investment grade securities, it was just 1.8%. Fixed-income coupons do not rise when central banks raise key interest rates. It is only when an issuer needs to refinance that borrowing costs become higher. In the primary market, a typical European corporate bond issuer has to offer almost 4.5% today. For some companies, the sharp rise in interest rates could make refinancing difficult.

This should therefore also have an impact on profits, dividends and thus share prices.

Bonds are becoming more favourable once againMost corporate bonds are still trading well below par, Iggo continues. Since they would have to be redeemed at par at maturity, their prices would tend to rise, which would support earnings. If there is a recession, there will be speculation about interest rate cuts, which are still expected in 2024. The yield curve is still strongly inverted, but any easing of monetary policy will contribute to a normalization, which is mostly good for bond investors.

However, because short-term interest rates are expected to continue rising for the time being, long-term yields have also risen. For the first time since November 2022, the US ten-year yield is above 4% again. New investments seem to make sense to Iggo. He expects bond yields to hover between 3.5% and 4% for a long time to come, or to deviate only slightly from this range.