Over the past year, interest rates and inflation have been front and centre for investors.

The invasion of Russia into Ukraine in February 2022, supply-chain disruptions, energy price spikes, and labour shortages have all contributed to the highest inflation levels in developed countries in four decades.  The effects have been felt globally, with central banks in various economies tackling the scourge of inflation by aggressively hiking interest rates. 

Central banks cannot do anything about the supply side. They cannot drill for oil or grow wheat. What they can do is make it more expensive to borrow and make interest payments, thereby inhibiting consumer and business spending. This also raises the levels of uncertainty from an investment point of view. With more than two years into this hawkish stance and variations in critical economic pointers, where to go for domestic and international interest rates from here?

In March 2022, the world’s most influential central bank, the Federal Reserve of the United States (Fed), raised its policy rate range by 25 basis points. This was the first rate hike since 2018. Since then, the Fed has increased rates 11 times. After its most recent meeting in July 2023, the benchmark range currently stands between 5.25% and 5.50%.

So far, it has had a limited impact on the pockets of Americans, as many have a fixed interest rate on their existing mortgage debt, but any new borrowing has to be done at prevailing rates. So anyone who took out a mortgage before 2022 is probably still paying around 3%, but someone looking to buy a house today will pay 7% – more than double.

Inflation has moderated substantially since reaching a peak of 9% in the middle of last year, but Fed Chair Jerome Powell said inflation “has a long way to go” before hitting the Fed’s 2% target. In an interview with business broadcaster CNBC, Powell said: “I would say it’s certainly possible that we would raise funds again at the September meeting if the data warranted.”

In the early part of the hike cycle, the Fed gave guidance as to where it thought rates would be going. But as we near the end of the cycle, the Fed will take every meeting as it comes and hence is “data dependent”. Of course, this raises uncertainty for investors on whether interest rates are still in play or have paused.

Domestically, South Africa’s Reserve Bank’s (SARB) Monetary Policy Committee (MPC) focuses on its mandate to target inflation between the 3% to 6% target band. However, it keeps a close eye on the Fed as US interest rates have a gravitational pull on global capital flow. This means that emerging markets like South Africa are forced to follow or even get ahead of the Fed so as not to experience destabilising outflows and sharp declines in their domestic currency against the US dollar.

Since November 2021, SARB’s MPC has pre-empted the US Fed with its hawkish stance, implementing 10 consecutive rate hikes in this cycle – ranging from 25 to 75 basis points and totalling 475 basis points. Following its most recent meeting in July, the bank left the repo rate unchanged at 8.25%, with the prime lending rate at 11.75% – a high last seen in 2009 when rates were on their way down during the global financial crisis.

This move came a day after consumer inflation significantly improved for June, falling to 5.4% year-on-year from 6.3% in May 2023 and 6.8% in April 2023.  Despite the better news on inflation, SARB Governor Lesetja Kganyago made it clear that “serious upside risks to the inflation outlook remain. Considering these risks, the committee remains vigilant, and decisions will continue to be data dependent and sensitive to the balance of risks to the outlook”.

What about the economy and the markets?

The way ahead is uncertain. According to the sentiments shared by Powell and Kganyago, risks to inflation remain and central banks are focused on not declaring premature victory in their fight against inflation. However, we are probably at or near the end of the hike cycle.

From a South African perspective, loadshedding remains a risk factor for inflation, with food producers, retailers, manufacturers and mining houses counting the cost of alternative electricity generation. Much of the costs are passed on to consumers – causing inflation – or how much is absorbed.

The Reserve Bank has repeatedly warned of the inflationary risks of sustained loadshedding, which has undoubtedly contributed to its decisions. Loadshedding is an additional burden for households at a time when high inflation and high-interest rates have put pressure on the finances of South Africans.

Slower economic growth is also of concern. The biggest issue is the principal infrastructure problems with electricity and logistics and the decline of service delivery in general, particularly at a municipal level. The other headwind is that commodity prices are lower this year after sharp increases in 2020 and 2021.

Despite these concerns, SARB is respected for using the tools within its ambit to address the short-term risks to domestic inflation despite the uncertainty this causes for the investment community. Investors appreciate the importance of having an independent central bank focused on stable inflation as an anchor for the long-term valuations of local markets.

So where to from here? Play or pause?

We’re near or at the peak of the hike cycle. Higher interest rates mean households and businesses are re-evaluating the cost and exposure to debt versus the benefits of saving.

Companies will have to re-evaluate any expansion plans against a higher cost of capital, and similarly, households will have to factor in higher mortgage payments before buying property. This should somewhat slow investment in the economy, but a longer-term view also needs to be considered. Most decision-makers realise this is a cycle, and rates will eventually fall.

From a portfolio-management point of view, higher real interest rates make cash and cash-like investments increasingly attractive. They have very low volatility compared to bonds and equities but offer decent yields. These investment fundamentals stand true across international markets. Short-dated fixed income is making a comeback in portfolio allocations. So perhaps, for now, some might say cash is still king.

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