I have published this video this morning. In it I argue that economics says high interest rates should deflate share prices. But that's not been true since 2021, because the real world does not work the way economics says it does. Instead, high interest rates have led to high share valuations. And now all that could change.

The audio version of this video is here:

The transcript is:

High interest rates have resulted in high share prices in the UK.

Now I know I've upset a lot of people by saying this, but I'm going to say it again.

High interest rates have resulted in over inflated share prices in the UK, and I suspect around the world. And that is one of the reasons why we are now facing market volatility in the world's financial markets and the risk of a recession, because those overinflated share prices are at risk of falling.

What I'm saying is the opposite of what I am supposed to put forward as an economic idea. According to conventional economics, if high interest rates exist, then share prices should fall. But they haven't. Since 2021, and I'm going to use the UK as an example, the rate of interest rose from 0.25 per cent - this is the Bank of England's base rate - to 5.25 per cent, and it's only just declined for the first time - now being at 5%.

Over that same period, the FTSE share price index rose from a bit over 5,000 to nearly 8,400. And if we go from mid-2021 to the events of July 2024, the increase was from around 7,000 for the FTSE 100 to 8,400 - an increase, in other words, in the index of 20%, which of course does not mean that every share price went up by that amount.

But what is clearly obvious is that during this period the claim that high interest rates should reduce share prices did not hold true. So, all of those who've been trying to tell me I'm completely wrong to say that high interest rates have resulted in high share prices are putting forward a falsehood, in my opinion, because I can see the evidence to the contrary in the real world all around me, not just in the UK, where I've just noted the figures, but also in the USA and elsewhere.

So, what has really gone on? Well, Let's explain it as simply as I can.

Those making the claim that they do, that high interest rates should reduce share prices, are following what is called economic theory. And economic theory makes some rather weird assumptions, one of which is that there are fair markets, and another one of which is that there is perfect information, and that everyone behaves rationally. And let's be clear, none of these things are true.

Let's, for example, talk about interest rates.

Interest rates are not subject to a fair market. Interest rates are basically determined by central banks who have the power to force the markets that they regulate to increase rates if that's what they say they want the market to do.

And, to use the example in the UK, because the Bank of England forced up interest rates, which they did, they forced down the price of government bonds. Most people don't get this relationship, so let me explain it very briefly with a very simple and somewhat exaggerated example.

Suppose we have a government bond that is issued for £1,000 for a very long period of time, thirty years or so.

And let's presume it's been an issue now for five years and it's been paying an interest rate of five percent. In other words, for every £1,000 bond that you own, you get £50 of interest each year.

Now the £50 of interest never changes over the life of the bond, but the bond can be bought and sold. So, if the Bank of England then decides after five years that it wants to force up interest rates, what it has to do is actually force down the price of the bond.

If, for example, it wanted to force interest rates from 5%, which is what the bond was issued at, to 10%, what it could do is force the price of the bond down until it was at £500 and then the £50 interest that was still being paid would of course be a 10 per cent return on the new price that the bond was being sold at on the second-hand market, and I stress very strongly “on the second-hand bond market” so you can see that if interest rates go up bond prices definitely have to fall.

Now, the assumption that is made by those who follow conventional economics is that if the interest rate has gone up then the price of shares must also fall because there is a more attractive alternative available to funds, which is to buy those bonds.

But those bonds aren't readily available because what happens when the bond price falls is that we don't have a free market in investments. We have a very Intensely regulated market in investment where investment funds have to report their performance normally every three months and they're always desperate to show an underlying increase in their rate of return.

So if there's a whiff that the price of bonds are going to fall and the fund has to report a change in its market valuation, meaning that holding those bonds means that the value of the fund will decline, then they will dispose those bonds. Then they will dispose of those bonds as soon as they can, because that avoids the risk of making that loss.

Now, of course, they then, as a consequence, deliver exactly what the Bank of England wants. The price of bonds goes down. But, all the money that was in those bonds doesn't just disappear, it's got to go somewhere. And what we know is that most institutional funds are very reluctant to hold cash, for the very good reason that that holding cash is highly risky for them because there is no guarantee on their bank deposits.

So, they have to hold assets. And the only other obvious asset for them to buy, if the price of bonds has gone down, is shares. They're not going to pour into land and buildings and other such things because they're very long-term structural investments, even for most of these funds. Instead, they'll go and buy some shares in the stock market.

The price of those shares in the stock market will then, because of the increase in demand, go up. That's the way that markets work. Now that's irrational, you might say, because, surely, they can make a better rate of return on bonds than they can on shares, because if the dividend doesn't go up, as a consequence of buying more shares, and there's no reason why it should, then surely their rate of return has declined?

But, and here's the catch. Suppose that the person who buys the shares can persuade themselves that actually it's rational to buy those shares, even though there's no evidence to really support that fact. We've seen this phenomenon over the last three years.

What we've seen is the phenomenon of AI develop and crash into the marketplace. And everybody who's been trying to justify why they will buy shares instead of bonds, which are going down in price, has been able to say, “It's okay. We can pay more for the price of shares because AI is going to deliver exceptional future profits which will justify us buying now before the price goes up even further when those profits are realised.”

It's all a myth, of course. Nobody knows that AI is going to deliver exceptional future profits. AI could be an absolute disaster. It may not work. It might not deliver outcomes that people expect because, let's be honest, however good the web was, it did not deliver all the hype that was talked about around 2000 and just before it.

And there is, therefore, the prospect that this AI boom is just a myth. Now, the reality is that this is why we might now be facing a real recession. But until this awareness that AI might just be a load of old myth had been reached, the markets were able to persuade themselves that it has been entirely rational to spend the money that they have realised from selling bonds that have been going down in price on shares that have as a consequence gone up in price.

Even though economic theory supposedly says otherwise, they, because of the institutional structures of investing, which requires them to put their money somewhere, have been able to persuade themselves that buying shares and inflating their prices has been rational. And we have seen those prices go up, until very recently, when they've started to fall.

Therefore, contrary to all the economic theory that says that high interest rates should result in low share prices, we've had high, indeed aggressively high, interest rates set by our central banks, and simultaneously we've had high share prices.

Those who tell me that I'm not following the theory and that I'm wrong should really open their eyes and look out of the window, read their newspapers, look at the charts that are published on the web or whatever else they might like.

Because the data in the real world tells me that high interest rates have inflated the price of shares. I don't see another explanation. Of course, a myth has been used to justify that inflation in prices, but without the cash to pursue those shares which came from the sale of bonds, that would not have happened.

And that cash has moved from bonds into shares. And, therefore, the price of shares has been increased. And that's been because of the change in interest rates. And I believe that's a fact. Or at least, it's my explanation of the fact. And I'm sticking to it, because it seems to me that that this explains most precisely why we are now in such a vulnerable position.

Interest rates have to fall because they're too high to sustain the economy, and the myth that has supported the high price of shares might also burst. If both happen simultaneously, we face a potential problem.

The lower interest rates might boost the economy a bit in the long term.

The fall in the value of shares and the shattering of the myth of AI, which might well happen, will result in an immediate loss in business confidence that could result in recession.

We're in a very dangerous place. And over high interest rates do, I believe, provide the explanation as to why that is the case.