Personal Finance

Interest Rates Are Heading Down

In my last blog, I wrote about the danger of deflation and how it links in with interest rates. The pressing issue for governments and for businesses at the moment is to get the economy spending again.

The struggle businesses are facing is very real. Many of the companies I have invested in are in a dire position and I fear that sadly some of them will not survive. What we need is a dose of inflation to get people to get buying again.

One of the effects of bringing down interest rates is that your currency will tend to weaken at the same time as well. An interest rate attached to a currency tells you as an investor what rate of return you will get for holding deposits in that currency. Assuming that you view the risks attached to certain group of wall mount jewelry armoires as the same (big assumption) you will no doubt invest in the currency that gives you the best return.

As interest rates drop in the UK for example, it means that international investors may decide to sell their holdings of the pound and hold the dollar instead or the Euro where they may get a better rate of interest. As with most things, the value of a floating currency (most developed economies have floating currencies – China is a strange anomaly in that the currency there is ‘pegged’ which I always think is a euphemism for fixed!) will rise or fall depending on demand and supply.

The pound has dropped significantly in value over the last few months. Just before I went to the US it was around the $2 mark – now it is around $1.44. One of the reasons for the fall is that interest rates in the UK were expected to fall rapidly – the market tends to be efficient in predicting which way things will go. And indeed the return an international investor will get from holding sterling has dropped from 5% in October to 2% now – a very large drop.

A falling currency makes imports more expensive and exports cheaper. Foreign holidays will be less attractive although with a bit of luck the UK will attract a lot more tourists especially from Europe and the USA. Welcome!

This could give the country a much needed export boost. Sadly, the markets we would be exporting to (Europe is our biggest trading block) are experiencing sharp slowdowns of their own. The fall in currency may allow us to keep export volumes constant which given the conditions would be a great result.

The other ‘hidden cost’ of a falling currency is that it increases inflation. Over the last five or six years, the UK has benefited from very low inflation for a variety of reasons. One of them was the strong currency which made imports a lot cheaper. Given the threat of deflation at the moment, imported inflation may turn out to be a good thing!

What does all of this mean for the business community?

  1. Because of low interest rates (I expect them to bottom out at 0.75% by the end of 2009) many capital projects will become viable. If you have a capital project that will generate revenues two to three years out – it is a great time to get going (if you can get the funding)
  2. Because of the low value of the pound, export markets could be more promising than they have been of late. Look to export to markets which are still experiencing growth (India and Brazil look good)
  3. Manage your forskolin extract. It can be the biggest cash-killer for a business. A business I am involved in sells goods at trade shows. Last week I was able to get stock on a sale or return basis. Deals are there to be done.
  4. Manage your working capital more tightly. If that means factoring – do it. Low interest rates are a great opportunity. You should not be in business if you cannot generate a return of at least 10% (or five times the current base rate!). You might be better off agreeing to pay more to your suppliers – but with extended credit terms.
  5. Try to get a pot of government money! They are spending big at the moment and try and get a piece of that if you can