In August, both the stock and bond markets experienced a downturn. The Euro Stoxx 50 index, representing major European companies, declined by 3.8%, while the S&P 500 index, comprising the largest US corporations, dropped by 1.8%. The decline was even steeper for riskier assets, with the MSCI Emerging Markets index, reflecting developing countries’ stock markets, losing 6.4% of its value, and the Chinese stock market falling by 5.2%.

The US Federal Reserve initiated a series of interest rate hikes in March 2022, culminating in 11 increases by the end of August 2023 and bringing the short-term interest rate to 5.25%. Despite a slowdown in the 12-month inflation rate by August’s end to 3.7%, it still surpassed the central bank’s 2% target. There is still a possibility of further interest rate hikes by the Fed later this year. Notably, the interest rate for 10-year US government bonds reached 4.11% by August’s end, marking a return to positive real interest rates in the US after an extended period.

In the first half of 2022, the European Central Bank imposed a penalty interest rate of -0.5% on funds held by banks. Since July of the same year, the European Central Bank has raised interest rates nine times, reaching 4.0% in September 2023. While real interest rates are positive in the US, they remain negative in the euro area, where 12-month inflation stood at 5.2% at the end of August – still exceeding both short-term and long-term interest rates. The interest rate on German 10-year government bonds stood at 2.5% at the end of August.

Some protection measures taken against rising interest rates

An intriguing analysis by Société Générale analyst Albert Edwards caught my attention recently. Edwards noted that despite the significant rise in interest rates, US corporate net interest expenses compared to after-tax profits are currently at their lowest point in 60 years.

Figure 1. Interest rate set by the US Federal Reserve (black, on the right scale) and the share of US corporate net interest payments in after-tax profits (red, on the left scale). Source: Société Générale.

It turns out that when interest rates were historically low, savvy business leaders secured long-term fixed-rate loans or issued as many long-term fixed-rate bonds as possible. After all, interest costs were practically non-existent. With short-term interest rates now surpassing long-term rates, these business leaders are actually earning more interest on idle funds in their bank accounts than they are paying on long-term liabilities.

Figure 2. Interest rate set by the US Federal Reserve (blue, on the right scale) and net interest payments by US companies (red, on the left scale). Source: Société Générale.

Albert Edwards suggests that this may contribute to the faster-than-expected economic growth in the US this year. However, it also implies that a reckoning may come once those long-term bonds need to be refinanced. Fixing interest rates has bought time to adapt to this evolving landscape.

This leads me to ponder how Estonia’s economic growth has been affected, given our heavy reliance on floating interest rates. While interest rates were declining, scarcely anyone in Estonia contemplated interest rate risk – the possibility of rates increasing. And when the rates suddenly did rise, many hoped it would be short-lived, with rates soon returning to lower levels. Relying on hope, however, is not the best strategy.

Figure 3. Six-month Euribor. Source: Euribor-rates.eu.

Just as with fluctuations in exchange rates or stock prices, movement in interest rates can lead to gains or losses. Remarkably, interest rates have been on a downward trajectory for approximately 40 years – surpassing the entire history of Estonian banking since regaining independence.

Even when banks offered customers options for fixed interest rates and risk mitigation, most customers preferred lower, floating Euribor-based rates.

Some even considered switching from the standard six-month floating rate, commonly chosen in Estonian banking, to the even lower one-month Euribor. Few contemplated protecting against interest rate risk; borrowers primarily sought the lowest available interest rate without considering long-term risks.

Figure 4. German 10-year government bond yields 2000–2023. Source: Bloomberg.

Promoting interest rate risk awareness is a vital component of financial education

Estonia is not the only European country with a loan market linked to floating interest rates, but I suspect few countries place as much trust in Euribor as we do. Floating rate loans are also popular in Greece, Portugal, Spain and Italy, whereas the French, Germans and Dutch tend to hedge their interest rate risk by opting for fixed rates.

The choice between floating or fixed interest rates often bears little consequence for business loans, given their typical three-year lifespan and frequent borrowing and repayment cycles. However, the interest rate plays a pivotal role in real estate loans due to extended loan durations and larger loan amounts relative to collateral values.

With short-term interest rates rapidly rising, the impact of central banks’ monetary policies becomes more pronounced in countries whose credit markets are tied to floating interest rates. Notably, short-term interest rates have escalated more swiftly and higher than long-term interest rates.

Yet, Estonians’ trust in Euribor remains steadfast. Colleagues from LHV Pank’s loan department affirm that customers continue to favour floating interest rate loans, even if they come at a higher cost than fixed-rate alternatives.

Typically, long-term loans command higher interest rates than short-term ones. In an era where interest rates had perpetually fallen, people forgot that there might be a limit to how low they could go. Even during negative interest rate periods, many believed that rates could go lower still.

With the spectre of inflation now looming, it is necessary to give greater consideration to interest rates, which applies to borrowers, lenders, and regulators alike. Should we consider adjusting our behaviour or exploring risk-mitigation strategies?

Essentially, interest rates represent the cost of money, rendering them the most important price within the economy. The price of money is even more crucial than the price of energy, as it impacts the value of all other assets, including stocks and real estate, given that the availability of financing influences societal development as a whole.

There is no way to control the price of money over long periods. This was exemplified by the failed attempts of the world’s most powerful central banks to manipulate interest rates and bond prices, resulting in an unexpected acceleration in inflation rates and a subsequent rapid interest rate hike.

However, precisely because the price of money cannot be regulated, it is imperative to understand how interest rates are determined and impact us all. We must determine which risks are worth taking and which should be mitigated. The price of money underpins all other prices.