- On 2 November the Federal Reserve raised rates by 0.75 points for the fourth consecutive time.
- It warned that the final level of rates would be higher than expected, and that they could stay high for longer.
- With high rates, the opportunity cost of tying up capital is measured again: every euro tied up has to be justified.
On 2 November 2022 the Federal Reserve raised interest rates by 0.75 points for the fourth consecutive time and warned that the final level would be higher than expected. Four successive rises of that size is an extraordinary pace in the recent history of central banks, and it confirmed that monetary tightening had not ended nor was near to ending.
The message had two parts. The first, that rates would keep rising. The second, more important in the long run, that the point of arrival would be higher than thought. For markets and for anyone taking financing or investment decisions, that means the environment of high rates was not something passing, but a scenario that had to be built into forecasts for the coming quarters. The combination of both messages had a stronger effect than an isolated rise, because it reduced the hope of a quick turn.
A fourth rise in a row
Four consecutive rises of 0.75 points mark a very intense tightening in little time. In addition, the Fed warned that the point of arrival would be higher than expected, which means rates were not only rising but could stay high for longer. In practical terms, each additional rise makes variable-rate debt a little dearer and reduces the present value of future cash flows.
To grasp the scale, it is enough to recall where things started: only a few months earlier, rates were at minimum levels. The cumulative jump in less than a year is one of the fastest remembered. The effects of such a fast rise are spread over time and reach different sectors with a lag, so it is reasonable to expect its consequences to keep appearing in the following months. Anyone with variable-rate debt will see these rises reflected in successive reviews, and the accumulation can be considerable.
High rates that last
Markets were pricing in that high rates would last. When investors believe money will stay dear, they adjust their valuations and decisions: investments financed with debt become dearer and new projects are required to yield more.
An environment of high and lasting rates favours those with liquidity and little debt, and penalises those who depend on frequent refinancing. It also changes how projects are evaluated: an investment that pays at a financing cost of 2% may stop doing so at 6%. That is why profitability analyses should be recalculated with current financing costs. Having money tied up in illiquid assets is not a problem in itself, but being unable to access it when needed is.
The opportunity cost
For long-term investments, the opportunity cost of tying up capital was again a variable that had to be measured. Opportunity cost is what is forgone by keeping money in one option rather than another, and with higher rates, the return required of an illiquid investment goes up.
Put practically: if money deposited in the short term earns more than before, an investment that ties it up for years must compensate with something more than the return of that time. It does not mean long-term investments cease to make sense, but that they must be compared with today’s alternatives and not those of a year ago. This note is general information, not investment advice. Asking how much of the portfolio or the business should be liquid at twelve months is a good exercise to start with.
With high rates, every euro tied up has to be justified.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
