What happens when rates go up?

Dollars

A look at the implications of rising interest rates in the US.

The US Federal Reserve has begun the painstaking process of raising interest rates, up to 0.5% to 0.75% in December, and has signalled 2017 will contain more of the same.

We believe that strong fundamentals support the idea that the US stands to grow at a faster rate than the 2.2% average estimate in 2017, which would strengthen the Fed’s resolve to embark on further rate hikes.

Slow as these changes will be, the effects have already started to ripple across financial markets. The question investors should be asking themselves is which sectors are likely to be most affected and what does that mean for your portfolio?

Here is a brief snapshot of how higher interest rates may impact the investment outlook.

US Financials

US financials are among the primary beneficiaries of higher interest rates. As rates go up, the spread between the federal funds rate and the rate at which banks lend money widens which generates greater profitability on loans.

Short-term rates are determined by the Fed, while it is the market which dictates longer-term rates. The overall picture is dubbed the yield curve as it depicts the rates on equivalent bonds of different maturities.

The yield curve typically slopes upwards since longer-term bonds are higher risk and require greater compensation in terms of returns. If investors believe interest rates will go up in the future, they will want adequate protection against the risk of higher rates eating into their fixed returns down the line.

Since banks typically borrow at the shorter end of the yield curve and lend at the longer, a steeper yield curve represents a net benefit for their profit margins.

Bank of America, for example, has factored in the effects of rising interest rates on its profitability. In its fourth quarter statement for 2016, the bank said that it expects Net Interest Income (NII) to increase $600m in the first quarter of 2017, assuming rates remain at current levels and there is modest growth in loans and deposits.

Growth in loans and deposits is in itself an indirect consequence of rising interest rates. The Federal Open Market Committee after all elected to raise rates in December in response to stronger economic activity and solid job gains. A stronger economy points to fewer non-performing loans on banks’ balance sheets as borrowers have an easier time making repayments.

Emerging markets

Emerging market (EM) economies are typically seen as at risk of bearing the brunt of stronger economic growth in the US. When higher yields are available in the US, investors are more drawn to safer assets such as Treasurys and are less inclined to take on riskier assets.

However, a significant number of emerging economies are net exporters of commodities. Our view is that a strengthening US economy would suggest there will be greater demand for commodities which would be of benefit to these economies. Commodities have only recovered a small proportion of the prices lost in the economic collapse, indicating there is room for upwards expansion.

Ongoing dollar strength, in part driven by rising interest rates, could present problems for EMs if it has the effect of depressing the values of emerging market currencies.

Fixed Income

The rate hike itself was priced into the federal funds futures market well in advance of the Fed announcement. While rising rates spell out a more positive message, in terms of a stronger economy, they can also present a more challenging environment for fixed income investing.

Research from BlackRock includes shorter duration bonds and Treasury Inflation Protected Securities (TIPS) as among those products better suited to a higher interest rate environment.

Duration is a measure of how sensitive a bond’s value is to changes in the interest rate. The longer the duration of a bond, the greater the impact changes in the interest rate will be. Since the price of bonds move in the opposite direction to interest rates, shorter duration bonds will lose less value in the event of rising interest rates.

As the name suggests, TIPS provide protection against inflation as the face value is pegged to the Consumer Price Index (CPI). The Federal Reserve’s decision to raise interest rates has been partly due to both realised and expected levels of inflation, which broke through the target rate of 2% in December. So as inflation climbs, sparking higher interest rates, TIPS become an increasingly attractive option.

 


The above article was first published by Charles Stanley on 27th January 2017.