It’s been well over a decade since the global financial crisis of 2008, and the global trend of low interest rates looks set to continue into the year ahead. What do treasurers need to know about interest rates going forward, and how can they weather the current stagnant environment?

The job of any central bank is to alter its money supply to try and manage the economy and control inflation through its base interest rate. When monetary policymakers decide to change interest rates, demand in the economy is affected via multiple channels.

In a nutshell, whenever interest rates rise, consumers with debts pay more in interest to lenders. This has a negative effect on consumer spending habits because if consumers have more money to pay to keep their loans current, the less disposable income they will have to spend on products and services. More are also inclined to save not spend.

On the other hand, when interest rates are cut, the cost of borrowing decreases for both businesses and consumers. This can help spur spending on capital goods – which not only helps an economy’s long-term performance, but can also help spur household expenditures on homes or durables like cars and white goods.

Tumultuous times

At present, the global economy is operating below potential and inflation pressures remain muted. Interest rates in many developed markets are still close to, if not at, emergency levels. This gives limited room for central banks to reduce rates further to stimulate growth.

The key major central bank that does have room to cut rates is the US Federal Reserve. Although the US economy remains relatively robust, its cycle is mature. It has had no negative quarter for more than ten years and inflation is below the Fed’s target level.

In late July, the Fed moved to an easing bias, cutting rates by 0.25% for the first time in over a decade. However, this was driven less by domestic growth concerns and more by global trade tensions.

In the UK, the Bank of England (BoE) has signalled many times to the market that it would like to gradually increase rates over the next two to three years and distance itself from the present emergency levels. Yet despite a strong labour market, the BoE has also been thwarted by Brexit uncertainty. This has led to falling business confidence and investment, with official figures showing that GDP contracted by 0.2% in the second quarter of 2019.

Taking all of these factors into account, how do central bank policymakers decide when to alter interest rates, and if so, by how much?

The Taylor Rule

The most famous guide for policymakers is the ‘Taylor Rule’ and is used to provide a reasonable explanation for why policy took the path that it did. At the core of the Taylor Rule is that inflation-targeting central banks have a trade-off between inflation and output. Above-target inflation puts upward pressure on the appropriate interest rate while a shortfall of demand relative to potential provides downward pressure.

In the original 1993 version of the Taylor Rule, equal weight was given to inflation and output shocks, but this itself depends on the reaction of the policymakers, and need not be constant through time.

A common mistake is to say that inflation or gross domestic product (GDP) growth is high and that the policy rate is therefore too low, but this is only true in a relative sense. An increase in GDP growth or inflation implies that the interest rate might need to be a bit higher than it otherwise would have been, but that is not the same as saying a change is needed.

According to Philip Rush, Founder and Chief Economist at Heteronomics, interest rate levels should always focus on gaps and levels, not the dynamic pace of the economy. “If the potential growth rate is also robust then demand may not be excessively stimulated,” he says. “Even with weak potential growth, if the level of output is a long way below potential, interest rates should be at low levels to stimulate demand back to its potential.”

Rush believes that failure to do this would leave disinflationary spare capacity that could cause a miss of the inflation target: “The value of the dynamic data here is their indications of the gaps and levels that matter, and they do so in a directly observable and less uncertain way than the various bits on the supply side of the Taylor Rule”.

Down to business

Interest rate risk can never be eliminated, and for many businesses, it is very much a centralised risk and must be managed. This can be done with accurate cash flow forecasts (see box), and by reviewing past trends for interest rates over both short and medium terms. It is essential that the risk profile of the company is adhered to, and that other legal requirements and documentation is in place so the proposed strategy can be executed.

Whatever the appetite for risk in any organisation, there are real opportunities for treasurers to earn improved returns on idle or investment cash balances. The ability to understand how any cash investment could be affected by a rising or falling interest rate allows treasurers to take immediate action. This will impact the current and future values of existing cash holdings, as well as influencing the relative attractiveness of different investment proposals.

As referenced in the Treasury Today’s September/October ‘Question Answered’, there are many different cash investment options available to treasurers, and each one varies significantly in its relationship to interest, and thus its capacity to mitigate risk. Of principal interest to treasurers are:

• Overnight bank deposits. Rates offered on overnight bank deposits tend to track interest rates fairly closely. However, given the lessons learnt from the 2007/8 financial crisis, treasurers should always review counterparty credit risk associated with the depositary bank. With some overnight bank deposits, there is also the option of earning credits to offset fees, interest or both.
• Time deposits. These can offer higher yields but tend to catch any rate increase with a lag, as they need to wait out the term of the deposit before being reset to a higher rate. Time deposits carry the same counterparty risk as overnight deposits but there is an increased liquidity risk. However, some minimum maturity time deposits can offer attractive yields and increased liquidity, versus longer term-time deposits.
• Money market funds. Compared to overnight bank deposits and time deposits, money market funds (MMFs) have a significantly more diversified counterparty credit risk and yields are in line with market rates.

So, in order to better navigate the current interest rate environment, it’s critical for treasurers to design and deploy a robust investment strategy that recognises trade-offs in yield, safety and liquidity.

Unless there is a decent pick up in global growth and inflation, or easing of trade tensions and politics, cuts look more likely than increases.

Paul Mueller, Senior Portfolio Manager, Invesco

An appetite for risk?

These investment options represent some of the most important ways changing interest rates influence demand. Having a solid understanding as to how, why and when they change, allows treasurers to take action to mitigate the impact of any changing interest rate cycle.

In effect, any change to interest rates leads to demand being pulled forward or pushed back, relative to when it might otherwise have occurred. Inflation expectations are also important. If expectations are high, interest rates will also need to be relatively elevated to allow real purchasing power to rise by an attractive amount through deferred consumption.

What today’s treasurer should be more focused on is the risk appetite of the organisation, and just how exposed it should be to any movement in interest rates. This is always a decision made by the board. Working closely with the board, treasurers should come up with an interest rate policy which broadly sets out the balance between fixed and floating interest rates that the business should have at any one time.

To fix or not to fix?

At present, and because interest rates are so low, there is a tendency for treasurers to be more floating than fixed. However, this will all depend on the nature of the organisation, depending on the type of the business and just how long it is holding that debt for. If a treasurer is focused on making sure the organisation is compliant with the board’s risk appetite, then it ultimately shouldn’t matter where interest rates are. However, rates should be consistently monitored to see if the risk profile of the company needs changing.

“Any rate cut or hike of 0.25 basis points should not make much of an impact on an organisation’s bottom line; unless of course it is operating right at the edge of its resources,” says Sarah Boyce, Associate Director, Policy and Technical at the Association of Corporate Treasurers (ACT). “Organisations operating in the housebuilding, project finance or aerospace industries typically borrow for the long-term. As a result, a view may be taken that fixing at a low interest rate for 30 years is so much more attractive than a long-term average of 5-7%.”

Equally, Boyce believes that an organisation which borrows on a short-term basis will typically take the view to keep floating because there is a possibility interest rates could fall further. “Should there be any increase in rates the impact won’t be as painful, so it is a much more nuanced question,” she adds.

Jonathan Pryor, Head of FX Sales at Investec agrees. “Short-term movements in interest rates are likely to prompt questions around surplus cash deployment,” he says. “In falling yield markets, treasurers may be considering options around either fixed-term or notice deposits which provide banks with favourable liquidity and therefore attract a higher yield than short-term funds”.

As markets begin to price in expectations of future rate movements into the yield curve, more strategic decisions will be made. Both the UK and US interest rate markets have expectations of cuts in the price of money already priced in, and this presents opportunities.

Short-term movements in interest rates are likely to prompt questions around surplus cash deployment.

Jonathan Pryor, Head of FX Sales, Investec

The future

The world is ever-changing, and with so much on the geopolitical and economic agenda, it’s very difficult to gain a clear perspective and accurate forecast on when rates may rise. The likelihood of rates rising in 2020 looks limited. The US economic expansion is mature, Eurozone growth is fragile, and inflation is a long way below its desired target.

“There may be idiosyncratic moves in some smaller economies but overall, unless there is a decent pick up in global growth and inflation, or easing of trade tensions and politics, cuts look more likely than increases,” says Paul Mueller, Senior Portfolio Manager at Invesco.

It seems that until inflation picks up, it’s likely that central banks will remain comfortable with current levels, and there could be the implementation of differing forms of quantitative easing such as the ECB’s Targeted Longer-Term Refinancing (TLTRO) operations. To date, banks are currently paying around €7bn per year to the ECB on cash parked there which exceeds mandatory reserves.

Regardless of what happens to interest rates in the coming months, the key question that today’s treasurer needs to ask is: “What will my business look like if interest rates are X%?”. Those businesses with an appropriate interest rate strategy in place will be best placed to respond.