Financial markets showed high levels of nervousness in May and June 2006, with many individual investors wondering whether the market drops were an opportunity to invest, or if it was time to pull out and look for safe havens.

Although market data shows a flight to bonds and low risk investments, one can difficultly understand why low interest rate bonds can be attractive whereas interest rates are on the rise. These are, apparently, conflicting signals between theory and practical findings.

Interest rates, leverage and working capital

The years after the .com bust saw all-time low interest rates and high liquidity creating an environment of low cost of capital. As a result, the real estate market boomed in the U.S. and business wise, borrowing for trading commodities was hot with the surge in demand from India and China. Overall, leverage was very profitable with low borrowing costs and big returns at a relatively low risk level for both banks and companies.

The same phenomenon happened in the financial markets. Leverage was an ideal tool to boost returns while the risks where kept at an acceptable level. However, the abundance of large returns at low risk levels was coming to an end when the U.S. Federal Reserve increased interest rates. Working capital requirements are more stringent when borrowing costs increase, and for commodities, the high prices put an even bigger burden on the balance sheet due to inventory costs.

Technology and business efficiency

High cost of capital and large working capital requirements puts many businesses in a difficult position. The time is right to think of technology to optimize all that can be optimized and that has been neglected for the last few years. A first obvious example can be found in working capital requirement optimization. Information services to track, map and decrease the capital frozen into inventory will be seen as the solution to the pains of many SMEs and even large caps.

Additionally, high commodity prices will drive nations and companies to increase the production efficiency. The first signals of this trend being the hybrid cars fashion and carbon credit trading.

As a result, the low interest rates were a fantastic opportunity for trading, but high interest rates mean that intelligent applications of technology will make their way to business efficiency.

Market transition and perceived nervousness

The time is right to decrease leverage, be it in working capital or in financial product investments, as the cost of borrowing increases. But this is not enough to explain why certain financial markets dropped by as much as 10%. It is important to note that the current times represent in fact, a fundamental transition in investments. Previously, low risk investments with relatively low returns could be turned into large returns while staying below a certain risk level by using cheap leverage mechanisms. With increasing interest rates, the returns decrease for the same leverage, and the risk-return levels to which investors are used to can not be achieved. Hence, investors seek different investment products to optimize the risk-return depending on the market parameters, and this translates in major shifts in investment portfolios. With large investors moving at the same time, markets are shaken and the individual investor asks herself what is going on.