Estimating Interest Rates - Key to everything!

This Article was originally published in The Global Analyst

“Investors looking for double-digit returns from fixed-income portfolios over the next one year can consider an allocation to long-duration funds. The maximum impact of a fall in interest rates is captured by long-duration funds.”

“Fund managers expect the Reserve Bank of India to cut interest rates by half to three-quarters of a percentage point (50-75 basis points) in the second half of 2024 following global rate cuts, which could lead to a capital appreciation in long-duration funds and lead to double-digit returns”

“The real rate - repo rate (6.5%) minus the estimated one-year forward consumer price inflation (4.5%) - is now 200 basis points against real rates of 150 basis points targeted by RBI. This opens space for 50 basis points of rate cut and, if the US economy slows down, the rate cuts could be 75-100 basis points to support GDP growth”

These are some recent extracts from business newspapers. They all focus on what Reserve Bank of India (RBI) is expected to do going forward which depends on what the Federal Reserve is expected to do. A key part of economic analysis involves estimating interest rates but that exercise can be tricky and those who get that part right would be laughing all the way to the bank.

Implicit in the interest rate determination is the concept of time value of money. In other words, the longer the duration, the higher the rate, ?as one is exposed to the risk for a materially longer time. Hence, yield curve (a group of interest rates from the very short term (say overnight) to very long-term say 30 years) reflect this relation between cost of money and time. The yield curve normally slopes upward and when it does not (meaning short-term rates are higher than long-term rates), they are called inverted yield curve.

In the enclosed table, we can see that 30-year government bonds have a yield of 7.129% while that of 3 months is at 7.040%, with other tenors in between. What is even more valuable is the spread or difference between different tenors (10year minus 2 years being the most popular).

How to read this table: Spread: The average spread observed between 10-year and 2-year bond; Change: The change in spread from one year to another. A positive change indicates increase in spread and vice-versa; Min: The minimum spread change observed within the range; Range: The highest and lowest levels of spread change observed; Max: The maximum spread change observed within the range.

A look at the spread evolution of 10y-2y shows that the difference need not be positive always. While the green candle stick indicates a positive spread, the red ones show negative spreads. The spread has historically remained at a range between a positive number of 130 bps (or basis points) and a negative number of 108 bps since 2015.

While market pricing determines the yield (like stock price), the Central Bank (RBI in this case) has a guiding role in terms of setting the pace and direction in what is called monetary policy setting. The RBI takes up this task through Money Policy Committee (MPC) which has several policy makers who decide the policy rate through intense deliberations. The MPC sets the “Repo Rate”- the rate at which RBI lends money to banks and in turn decides the loan and deposit pricing of banks. By implication reverse repo is the rate at which banks lend to RBI.? RBI now adopts what is called flexible inflation targeting (FIT) framework since 2016. Central banks worldwide believe that price stability (read as inflation control) will lead to financial stability, which will further raid growth. A stable and low inflation can help everyone from households to corporates to plan their affairs, be it spending plans or project financing. Stability is at the core of innovation, productivity, and sustainable growth. RBI targets inflation to be under 4% with a margin of +/-2%. Considering this, RBI will provide forward guidance on inflation and growth for investors to develop their expectations.

Post the Global Financial crisis in 2008, the Federal Reserve of US reduced the interest rates to 0.25% and kept the rates at that low level for nearly a decade before hiking them again. But then, the Covid pandemic that began in 2019 forced Central banks all over the world to slash interest rates again. RBI reduced policy repo rate by 115 bps between March to May 2020, and subsequently raised the repo by 250 bps between May 2022 to Feb 2023. This is just to give examples of the scale and speed with which interest rates can dance based on evolving economic circumstances. Hence, the difficulty in estimating the interest rates.

While RBI primarily uses Repo rate as its tool, it can also shape interest rates based on liquidity management in the market (by either inducing or absorbing the liquidity). The weighted average call money rate (WACR) is the average of the overnight rates and can sometimes differ vastly from the repo rate based on RBI’s intentions. If RBI decides to tighten financial conditions without a formal rate hike, it can use the liquidity lever to achieve its objective. It is important to appreciate the role of interest rates in determining asset class performance.

Bond Markets: Interest rates determine bond market performance in an inverse way. An increase in interest rates will result in a fall in the bond price (and vice-versa). Hence, a falling interest rate regime produces a bull market in bonds and vice-versa.

Equity Markets: Interest rates affect equity markets primarily through the valuation angle where the cost of capital (being the denominator) is again inversely proportional to the value. As interest rates go up, the derived value of a stock falls and vice versa. We can look at the spread between bond yields and earnings yield (the inverse of p/e ratio). This measure is again very volatile and has ranged from 0 to say250 bps in the last 5 years and is presently at the highest level. The long-term average is 120 bps. When stock valuations rise, the earnings yield falls.

Real Estate: In the realm of real estate, the impact of interest rates can be understood via cap rate (defined as net operating income divided by the property value). Higher interest rates should lead to higher cap rates and vice versa.

Currency: Interest rates also affect currency value as higher USD exchange rates will trigger a reverse flow of money from emerging markets like India back to US, which may well produce currency depreciation.

In conclusion we can say that interest rates affect corporate profitability and project financing and hence capital markets. Economic uncertainty, in the form of higher global inflation, supply chain shocks, geopolitical threats, all shape the yield curve which is presently inverted (globally). Inflation and interest rates are connected to each other like the umbilical cord and hence forecasting inflation is also ridden with the same uncertainty as forecasting interest rates. If inflation is left unattended at high levels, it can sow the seeds for higher inflation expectations (in what is called anchoring) and when that sets it, it is difficult to control inflation. Hence, Central Banks move decisively the moment they sense trouble in the form of higher inflation by hiking interest rates. Capital market players (be it bond fund managers or equity fund managers) should be adept at forecasting interest rates, though this economic exercise is simply the toughest.