Can the CBN’s interest rate hike improve investor confidence?

On the 19th of July 2022, the Monetary Policy Committee (MPC) announced a 100 basis points (bps) hike in the Monetary Policy Rate (MPR) to 14%; while maintaining the status quo in other monetary parameters.

Members of the committee were unanimous in their decision which they hoped would tame rising inflation and narrow Nigeria’s negative interest rate gap to stimulate investment flows.

This hike was the second this year, following an initial 150bps increase to 13% in March 2022. The decision by the MPC reflects a conscious effort to keep pace with runaway inflation and further incentivise people to hold on to the naira.

Considering that this decision is consistent with the interest rate hikes across money markets worldwide, it is not surprising. As we have written about previously, there are telltale signs of a global recession, and rising inflation has prompted these interest rate hikes across the globe.

The most recent being the 4th rate hike by the US Fed by 75bps to the upper limit of 2.50%, and the European Central Bank (ECB) raising rates for the first time in 11 years by 50bps to 0%.

The question here is, what do these rate hikes represent, and what do they mean for investors?

It is worth noting that I will not be giving any investment advice. But I will unravel the rationale behind the rate hikes done by the MPC, what they hope to achieve and some of its limitations.

So let's begin. What are these interest rate hikes? 

It's all about the money!

Interest rates are one of the essential tools in the CBN’s monetary policy toolbox. Basic economics defines monetary policy as a set of actions utilised by the monetary authority (usually the Central bank) to achieve sustainable growth. In other words, these policies affect macroeconomic variables such as GDP growth, inflation, exchange rate, unemployment, etc.

The central bank uses three main tools to achieve its set goals: Interest rates, Open Market Operations (OMO) and cash reserve requirements (CRR). Today, we would be looking at interest rates alone.

The central bank sets what is known as a benchmark interest rate, and this is the rate that determines other interest rates. It reflects the cost of borrowing money in different markets.

Think of it as the minimum cost of borrowing. So interest rates on bank loans, fixed income assets, mortgages, bank overdrafts, interests earned on savings accounts etc., are all “benchmarked” against the interest rate set by the Central bank. 

So what’s the economic effect of interest rate hikes? 

As I mentioned, global central banks have increased interest rates to curtail rising inflation. Inflation is a general rise in the prices of goods and services, usually* brought about by increasing demand.

For example, in the US, the various stimulus packages provided by the government to citizens during the Covid-19 pandemic helped maintain consumer spending even though the pandemic led to a complete halt in the production of goods. Therefore, demand remained strong, but no supply to match it, so naturally, prices began to increase (inflation), and the economy began to overheat.

This situation was further exacerbated by the Russia-Ukraine war that caused energy and commodity prices to skyrocket, taking US inflation to 9.1% in June 2022—the highest in over 40 years. 

So along came the US Fed (the equivalent of our MPC) to raise interest rates (contractionary monetary policy). The rationale is simple: when a country is experiencing high inflation (brought about by an increase in demand, which leads to higher prices), the central bank increases the benchmark interest rate. This increase incentivises people to save more rather than spend due to higher returns (interests) on investment securities like treasury bills and bonds.
 

However, there’s a flip side. When loan interest rates go up, people and firms are discouraged from borrowing and expanding, which could lead to lower economic growth.

Therefore, a reduction in interest rates (expansionary monetary policy) by central banks serves to boost economic growth. We saw this in 2020 as global central banks cut interest rates to cushion the negative impact of the Covid-19 pandemic that brought about increased poverty levels and a global recession.

Again, the rationale behind it is simple: lower interest rates mean people and companies can borrow more, as it's now cheaper to do so, demand and economic activities pick up, and the GDP grows.

The MPR is a vital tool affecting almost all macroeconomic variables, including the exchange rate and capital flows.

But, the rest of this article will focus on how the hike in MPR affects investment flows into the economy. 

Interest rates and investment flows

The idea behind this is also simple. 

Investment funds move across markets. Intuitively, this means that the economies which offer attractive real interest rates (more explanation on this soon) would see higher capital flows. As a result, the economy improves its current account position (difference between fund inflows and outflows) and witnesses exchange rate stability.

I’ll explain further.

Foreign investors (asset managers and hedge funds) do not own these funds. They invest, i.e., borrow from banks or a group of people at an agreed interest rate (cost of borrowing). They always seek to borrow from economies with lower interest rates and then invest in economies with higher interest rates. This is simply known as carry trade. 

The receiving economy requires that these foreign currencies be converted into their local currency before these funds can be used to acquire the investment securities. The induced demand strengthens the local currency's value (at least in the short run).

Imagine Damini is an investor that stays in Spain, where the benchmark interest rate is 0% (fun fact, it was previously -0.5%, meaning the European Central Bank (ECB) was essentially paying him to save). Now he sees that interest rates in Nigeria have increased from 10% to 15% due to high investment demand. Damini then remembers he was just about to invest his 13th-month salary of $10,000 into some ECB bonds with a 0.5% interest rate. So he quickly calls his broker to buy bonds in Nigeria instead. He does this because he expects to receive higher returns on his $10,000 even after accounting for exchange rate risk (risk of losing value on funds due to devaluation).

But before Damini can buy the Nigerian bonds and enjoy those juicy returns, the CBN requires him to change his dollars to naira, thereby increasing the supply of dollars in Nigeria and the demand for naira. The increased supply of foreign currency weakens the greenback’s value against the naira, while the need for local currency serves to appreciate the naira.

In other words, this brings more dollars into the system, giving the CBN more ammunition to defend the naira.

Theoretically, this inflow is what the CBN hopes to achieve by raising interest rates— to attract investment flows, which mainly applies to foreign investors.

However, remember the reason the MPC gave for the hike in interest rates—to tame rising inflation and narrow the negative interest rate gap to stimulate investment flows. An essential part of that statement is “... to narrow the negative interest rate gap”.

High interest rates alone can not be enough to attract investors. Investors also consider inflation in addition to the difference between interest rates and inflation which is the real interest rate and the most crucial bit that affects investors. Let’s see how. 

The inflation-interest rate saga

At Stears, we have emphasised the negative impact of inflation on consumer purchasing ability and investment returns. We explained how an individual earning ₦200,000 for the past five years (2018-2022) can only afford goods worth ₦164,560 now when you account for inflation eroding purchasing power.

Similarly, our Head of Intelligence—Michael Famoroti, correctly argues that double-digit inflation could wipe out any investment returns. 

In the words of Margaret Thatcher, “Inflation devalues us all.”

So anyone looking to invest in an economy has to account for inflation. Foreign investors have it even worse because they have to account for exchange rate risk (volatility in exchange rates that affect the value of returns).

To be clear, foreign investors are mainly exposed to exchange rate volatility and fx liquidity, as the former affects capital repatriation and the latter the availability of fx to meet demand; however, we are considering the impact of high inflation for the sake of this article.

High inflation contributes to a higher country risk premium—the extra return demanded by foreign investors to invest in our risky economy, as opposed to their local economy.

This means that a way of swaying investors into bringing these funds into your economy involves using returns on investments (interest rates) to match or outpace the inflation rate.

Permit me to recycle Michael’s example: “if I find an investment product that doubles my money in a year, I am less bothered when inflation eats 20% out of these funds. But if my investment product only gives me a 10% return, then I am even worse off when we account for inflation.”

In essence, investors are typically looking for investment returns higher than inflation. So if interest rates give returns higher than inflation, this is referred to as a positive real interest rate economy. Real interest rate simply refers to the interest rate adjusted for inflation, i.e. nominal interest rate (interest rate unadjusted for inflation) minus inflation.

So the CBN’s interest rate hike is also in the hopes of closing the gap between the nominal interest rate and the inflation rate.

As we can see from the graph, the inflation rate in Nigeria is above the nominal interest rate, meaning investors are losing value in investing in the Nigerian economy. 

Nominal interest rate: The 10-year government bond

To look at the nominal interest rate in any country, investors typically refer to the yields on the 10-year government bond because it is seen as an indicator of investor sentiment about the economy's direction in the medium term. It is also an essential macroeconomic indicator as it is a part of the yield curve (a line graph that plots interest rates of different tenured fixed income instruments).

The yield curve's slope can tell you about the investor confidence in the economy. Usually, when the yield curve is upward sloping (positive), yields on longer-dated instruments like the 10-year bond are higher than yields on shorter-dated instruments like the 91-day treasury bill.

This makes sense because, as an investor, you will expect to be compensated more for the risk associated with investing in a country’s bond for ten years than the risk associated with investing for just 91 days.

So if the yield curve is inverted (negative), the shorter-dated instruments have higher yields and hints that investors are pessimistic about the economy's future. Investors then use this decision when considering their investing strategies.

For example, during the early stage of the Russia-Ukraine war in March 2022, when looming inflationary and recessionary pressures had just started rearing their ugly heads, the 2-yr treasury yield was briefly higher than the 10-yr treasury yield in the US. This signalled concerns for the US economy in 2022.

Since the announcement of a contraction in Q1 2022 GDP growth in the US, increased fears of a recession fueled by rising inflation have led the yield curve to its lowest point since 2006. I.e. The 2-yr yield is now higher than the 10-yr yield.

Furthermore, because government bonds are regarded as “risk-free”, i.e., backed by the government's full faith, the government is obliged to pay and usually pays back. The yield on the 10-year bond is also used to measure against other riskier investment classes like stocks (equity market).

Investors can expect to get 20% per annum on a safe instrument like the 10-yr bond, which helps them determine the expected returns of other riskier investments and if those other returns are even worth the additional risk.

Another interesting thing to note is that interest rates and stock performance move in opposite directions, i.e., higher interest rates induce some sell-offs in the stock market. 

I mention this because the stock market is also an investment option available to investors willing to take on additional risk by investing in the more volatile stock market in exchange for higher returns. The higher the risk, the higher the returns.

The rationale behind the inverse relationship between interest rate and stock performance is twofold. First, as interest rates on fixed income instruments such as bonds, treasury bills and even fixed deposits rise, investors will generally gear towards them. They are “safer assets” and offer relatively higher returns.

Essentially, investors will now become more risk averse toward the volatile stock market that is more sensitive to the economy's fragile state.

The second rationale goes thus: when you buy shares of a particular company, you’re paying now for the money you hope to receive later. Essentially, you invest in a company because you expect it to make more money in the future as they pay dividends. Hopefully, the stock price of the company also goes up.

However, rising interest rates dent those hopes, as it becomes more expensive for these companies to borrow, eating into expected cash flows and even dividends. In some cases, companies get discouraged from borrowing altogether, putting pressure on those growth plans you had hoped for, so you sell off your positions.

So, while higher interest rates are good for investors in the fixed income market, they are not as positive for the stock performance.

That said, there is no evidence to suggest that higher interest rates lead to negative stock market performance in the long run. Usually, interest rates go up when the economy is booming, so the stock market should be performing well. Investors could just take some profit in the short run.

Some sectors and asset classes like the banking sector, real estate investment trusts (REITs) benefit because higher interest rates translate into more income for them. In comparison, others like the Tech and Industrial sectors are negatively impacted because they require a lot of debt financing to operate, and higher interest rates affect profitability. Reactions to Fast Moving Consumer Goods (FMCGs) are mixed because they can pass on higher costs to consumers. 

Now that we've established the importance of interest rates in influencing investors’ decisions, we need to see if increasing the MPR is enough to stimulate investment inflows.
 

Bonds and MPR

To know this, I need to explain some terms such as bond yields, interest rates and prices to help us understand this analysis.

As we know, bonds are debt instruments issued by a borrower (a company, state or federal government) and guarantee the investors a fixed amount of returns over a specified period.

From the day bonds are issued until they mature, they are always available to trade in the open market, where their prices and yields change constantly. These changes mean yields can converge to a point where they become approximately the same.

So, imagine that Stephanie had ₦1 million to buy a bond at issuance, with a yield/interest of 10%, she will pay ₦900,000 (₦1 million minus ₦100,000—the 10% yield). Throughout the bond's lifetime, she receives the fixed coupon/interest rate of ₦100,000 (10%) and then when it matures, the government pays her back ₦1 million.

You can see the difference between yields and interest rates (even though they are used interchangeably).

Bond yields are simply calculated by dividing the coupon/interest payment by the current price (expressed in percentage), i.e., Bond yield = Coupon payment / Price = ₦100/₦1000 = 10%.

Again, consider an example where the Federal Government issued a 10-yr bond “A” today with a face value of ₦1,000 and a coupon or interest rate of 10%. This means that over the next ten years, the Federal Government will pay investors 10% of ₦1,000 (₦100) every year and then pay back the lump sum of ₦1,000 at the end of the ten years.

Because this bond can be traded, it has an initial price of ₦1,000 and a yield to maturity of 10%. The yield here represents the discounted rate you get when you decide to buy the bond.

However, six months down the line, MPC hikes rates and interest rates begin to go up, and the FG issues another bond, “B”, with a yield of 15%.

Which sane investor will purchase bond A with a yield of 10% when we have bond B with 15%? No one would. It's essentially the same risk-free federal government investment but with higher returns. So what happens is that the original price of bond A has to adjust downwards to attract buyers.

But how?

First off, remember that the coupon rates on these bonds don’t change. So for bond A to be attractive to investors, its price must fall to around ₦665 for its yield to be at par with bond B.

Refer back to the formula for bond yields, so ₦100/₦665 = 15%—the same yield as bond B.

Of course, this doesn’t happen to the exact letter in real life. Still, it offers an important insight to this analysis: Bonds and interest rates move in opposite directions, i.e. inversely correlated.

Think of it this way interest rates impact yields. When they go up, bond prices fall. So when you hear that the yields of bonds went up, it's a negative condition for the bond market because prices are down.

This relationship occurs due to the demand and supply of investment money. With enough demand for bonds, the CBN wouldn’t be forced to raise rates to attract investors. So when they raise rates, they aim to attract investors back into the market. This new demand should now drive bond prices back up and, in turn, rates back down.

Conversely, prices will go up when rates fall, say from 10% to 6%, because that initial 10% bond is now hot cake for investors, indicating a positive bond market performance.

So let's take a look at the performance of Nigeria’s bond market and try to deduce if the interest rate hike might be enough to whet investors’ appetite. 

Rising yields spotlight the lack of investor confidence

As we can see from the chart, yields across most naira-denominated fixed income assets have increased over time, indicating a negative bond market performance. Investors have been selling off naira assets.

The negative real interest rate I addressed above and speculation over the naira devaluation and the higher interest rate environment in advanced economies have triggered the sell-offs.

Interestingly, when we look at the Eurobond (bonds issued in foreign currency) curve, it tells a more dire story.

This curve is critical because a chunk of these eurobonds are held and generally preferred by foreign investors because they are paid interests in the foreign currency in which the bond was issued. These bonds are generally benchmarked against the 10-yr treasury bond in the US. 

‘We can see here that the spread between Nigerian eurobonds and the 10yr US treasury bond has been widening. Current yields of most Nigerian eurobonds are above 10%—triggering “junk bonds” classification.

In simple terms, when eurobond yields go above the psychological limit of 10%, investors tend to rate these bonds as junk, meaning these bonds carry a higher risk of default than most bonds issued in other countries like America, where the yield on the US treasury is currently 2.8%.

Yet Nigeria’s foreign reserves were at $39.4 billion as of 15th July 2022, a healthy position when you consider that Nigeria’s next eurobond maturity is just $500 million and one year away (July 2023).

So despite higher oil prices and this relatively comfortable level of reserves (which shows the government’s ability to pay back), investors are less confident about Nigeria’s future in the short run.

This lack of confidence is possibly due to limited odds of improvements in external reserves given the skyrocketing fuel subsidy scheme and even uncertainties around the upcoming elections.

From a structural perspective, we can infer that this is a sign that confidence in Nigeria has weakened owing to several factors: persistent insecurity, widening budget deficit, policy somersaults, the current exchange rate regime and a complete lack of faith in the CBN Governor—Godwin Emefiele etc. These examples contribute to the higher country-risk premium I described earlier—i.e., the extra return demanded by foreign investors to invest in our risky economy, as opposed to their local economy.

As we can see, most of these issues can’t be fixed by simply hiking interest rates. In addition to a deliberate effort on the part of the CBN to win back investor confidence, the fiscal authority (the Federal Government) also needs to support monetary policy. This support will ensure rate hikes can be effective in the first place.