Why investors should pray that central banks cut interest rates in 2023

Central banks have pushed through 355 interest rate increases in 2022 and made only 15 cuts, according to the website cbrates.com. Global stock and bond markets have slumped and investors are praying that central bankers will reverse course and start lowering the cost of money in 2023.

This is because the direction of interest rates is very important to how investors allocate their capital among different assets. The available yield on cash, and thus the “risk-free” rate available on government bonds, determines the reference point by which the attractiveness or otherwise of all types of assets is judged.

risk free rate

For much of the past decade, bullish investors have argued that stock prices should rise because record low interest rates and government bond yields mean “there is no alternative.” To get any kind of return on their money, they had to look at different, riskier assets.

The test now is whether higher yields on cash and government bonds lead them to take less risk and demand lower prices for riskier assets, because they feel they don’t need them most. Savers must also factor in inflation: it is the “real” post-inflationary returns that matter.

The return offered by government bonds is usually seen as a risk-free rate for investors in that country, because, in principle, the government in question will not default on its obligations. He will always be able to make interest payments on time and return the initial investment as soon as the bond matures, even if he must print money to do so.

The last time Britain defaulted was in 1672, under the “Stowage of the Exchequer” under King Charles II, the 10-year gold bond yield is usually seen as a risk-free rate for British investors. At the time of writing, the 10-year gold yield is 3.6%. This is the minimum nominal annual return on any investment that any investor must accept.

risk and return

Any other investments carry more risks, so the investor must demand more from them.

Investment grade corporate bonds should yield more than government bonds because corporations can really go bust and management teams can do silly things. High-yield (or “junk”) corporate bonds must yield more returns than investment-grade bonds because the companies that issue them are more indebted and the risk of bankruptcy and default is higher.

Stocks should offer a higher total return potential than junk debt, because stock prices go down as well as up, while junk bonds will offer predetermined interest payments and initial return on investment if all goes well.

Thus, the returns that investors demand to compensate themselves for the (additional) risk will theoretically move relative to the gold bond yield, which will in turn be affected by central banks’ official interest rates.

The price must be right

For stocks, this can mean paying a lower valuation, doubling dividends and cash flow, and possibly demanding a higher dividend yield (achieved by buying at a lower share price).

Remember, total return per share is determined by the capital return plus the dividend yield and that the return on capital will be, in rough terms, a function of earnings growth and the dividend multiple that you pay for earnings growth.

In its simplest form, this can be seen in the price-to-earnings ratio (p/e). Earnings will rise (or fall), depending on the business cycle, the position of the company in the economy and the acumen of its chiefs.

The price paid or multiple can be affected by many things, including a company’s finances and management efficiency, as well as the predictability and reliability of its operations and financial performance.

Interest rates will have a big role in the complications as well. If gold rates and returns rise, investors may feel less inclined or obligated to take more risks with stocks and other assets when safer options offer better returns, at least on a pre-inflationary basis.

As a result, they may decide to pay lower prices and multiples, which is why stock markets can slide as prices go up.

Ross Mold is the investment manager for stockbroker AJ Bell

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