The rising cost of capital

I wanted to expand on a previous post from Jan 18, 2012 titled “What if interest rates double”.

What if the cost of capital doubles or triples within 10 years?

I don’t think this outcome is far-fetched and I do think it is worth considering or at least being prepared for.

In the U.S., the Prime rate is currently 3.25%, a 15 year fixed mortgage costs 3.4% per annum and the government 10 year bond is yielding 2.2%. Australians pay 6.5% for a 3 year fixed home loan while the Reserve Bank of Australia’s Cash Rate is presently 4.25%.

Whether it’s the mortgage, government or capital markets, rising rates in the coming decade shouldn’t be a surprise. After all, they are at the extreme low of their historical ranges.

Continued cheap credit isn’t something we should wish for. Take a look at Japan. Deflation is the larger evil.

Presently, central banks are trying to reflate economies and the result of the increasing monetary base should be inflation. How high it will rise will depend on the policy employed to curb it from becoming hyper-inflationary. One strategy that will be used will involve raising rates in order to slow a recovering and expanding economy.

We should remember that rate cuts are used to stimulate activity. Keeping rates low for a prolonged period tell us either how sick an economy is or how much of a “jump-start” the economy ultimately needs.

I think that rising rates should be (quietly) celebrated as they signal an expanding economy. The rising cost of credit is designed to temper the growth or least keep it at a measured pace.

Rates will rise noticeably in the next 10 years from the combined results involving policy, creditworthiness, lending criteria and the flow of money.

Although economies should improve, the inflationary effects of central bank “money printing” and the legacy of company and government bond defaults will be the greater influence towards the cost of credit rising.

Scarcity of capital will be the second wave of upward pressure on interest rates. Banks will be required to hold greater liquidity and their lending criteria will remain tough but more importantly I believe money will flow increasingly from the developed world towards emerging markets, where the return on the capital invested will be a more attractive proposition to lenders.

This exodus of capital will cause interest rates in the developed world to move higher. It’s quite possible that the rise will be amplified by erroneous central bank policy because they deem higher rates are justified in order to stifle the inflationary result from their actions earlier in the decade.

These higher rates will also be used (and justified) in order to court capital back to safer investing jurisdictions.

The ramifications of this scenario would have far-reaching effects on their portfolios and I feel it is an important theme in which investors will need to prepare and position for.

In an upcoming post, I will apply this theme to how I think it will affect commodity prices and mining companies.

%d bloggers like this: