Where to with interest rates?

Inflation and interest rates tipped to make a comeback


Opinion
It seems we are ending a fiscal cycle, and with that will likely come interest rate hikes.

It seems we are ending a fiscal cycle, and with that will likely come interest rate hikes.

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Crude oil prices remain high, US interest rates are on an upward trajectory, and we find ourselves in the latter stages of an economic cycle.

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Global equities were a little higher over the past week helped by a rebound in Asian share markets.

The Fed hiked rates 25 basis points as expected, taking the Fed fund’s target rate to 2.0-2.25 per cent, while keeping its 2018, 2019 and 2020 dot plot for future hikes unchanged.

Chairman Jerome Powell noted the Federal Reserve Bank could raise rates past the perceived neutral level.

Furthermore, oil prices rose to their highest levels in several months as Iranian oil export sanctions and falling inventories in the US continued to support crude prices.

In last week’s article I touched on portfolio construction and talked about the importance of duration, particularly holding high quality bonds and the role they play in an investor’s portfolio.

As we near the latter stages of the economic cycle, interest rates tend to rise. While this is not happening in Australia yet it is happening in the US.

Globally we are witnessing central banks unwind their quantitative easing programs and the Federal Reserve in the US is gradually increasing interest rates.

After a long period of very low interest rates this has implications for overall portfolio management.

We have had the view that interest rates are on an upwards trajectory as major central banks normalise monetary policy and inflation picks up. We have reduced our exposure to duration through investing in short duration instruments such as hybrids and floating rate notes.

Duration can be defined as the sensitivity of a fixed income asset to changes in an interest rate.

The longer the duration, the more sensitive the fixed income asset is to a change in interest rates.

When interest rates rise, longer duration assets will fall in value more than those assets of a shorter duration.

We have had the view interest rates are on an upwards trajectory as major central banks normalise monetary policy and inflation picks up.

Over the last few years we have reduced exposure to duration through investing in short duration instruments such as hybrids and floating rate notes.

However holding duration assets in a portfolio has a protective benefit, why?

During a market downturn, risk assets will experience significant falls in value.

Duration assets, such as high quality government and corporate bonds, are generally uncorrelated to equities and will offer a cushioning effect in a portfolio when equities fall in value.

The perceived stability of the underlying bond issuer and low risk of default make these assets attractive in market downturns.

Fixed income investments like bonds will continue to pay a stream of income through market cycles and retain their face value at maturity.

Hence the chance of capital loss for the investor is low if the bond is held until maturity.

So when do we add duration assets back into our portfolios?

At the end of an economic cycle and when market sentiment falls, risk assets (particularly equities) will experience sell offs and outperformance of high quality fixed income assets is usually evident, particularly in the form of government and corporate bonds.

The end of the economic cycle will usually signal the end of a rate hiking path by central banks and therefore longer duration assets will look more attractive.

Therefore investors need to be aware of key indicators that signal the latter stages of the cycle, one such metric is credit spreads.

  • This article does not take into account the investment objectives, financial situation or particular needs of any particular person.  Accordingly, before acting on any advice contained in this article, you should assess whether it is appropriate in light of your own financial circumstances or contact your financial adviser.
  • Christopher Hindmarsh is an adviser at JBWere. NAB owns JB Were.
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