Tags: Investment | Interest Rate | Panic | Bonds

Looming Interest Rate Rises No Cause for Panic

Friday, 10 January 2014 10:36 AM

As the era of money printing draws to a close, the prospect of a cycle of rising interest rates over the next couple of years appears daunting for investors and households so used to cheap credit.

But the anxiety may be overdone.

A tightening of monetary policy in rich economies — where some expect rate rises as soon as the end of this year — may only see rates climbing by around half as much as in previous episodes.

Editor’s Note: 38 Trades That Could Turn $1,000 Into $49,000

While consensus forecasts still put rate increases in the more buoyant economies of Britain and the United States far into next year, the end of fresh stimulus puts the prospect firmly on the horizon for many investors and businesses.

"That's the enormous elephant in the room," said Bill O'Neill, chief U.K. strategist at UBS Wealth Management.

"As we get down to the back end of 2014, we're more susceptible to shocks."

But O'Neill said the inevitable angst about rate rises should be tempered by a durable economic recovery extending far into 2018 and the likelihood of a much lower peak for interest rates as a result of persistently low inflation.

While there is almost a one in three chance of the Bank of England raising rates or strongly signaling a rise this year, he said the full cycle of hikes may only be 100-125 basis points — around half of the average since 1975.

Partly allowing the smaller scale of rate hikes is the effective tightening which is likely to accompany any wind-down of the BoE's existing quantitative easing purchases.

About 80 billion pounds of gilts on the BoE's balance sheet will mature in the next four years. The bank's current policy is to reinvest the proceeds, but it may decide to let them mature. That would help shrink its balance sheet, effectively taking liquidity out of the system.

"The complicating factor is money sloshing around the system. The BoE balance sheet is shrinking in 2015 and 2016. There will be tightening going on because of maturities," O'Neill said.

Even though Britain may be at the forefront of the rate cycle, a similar story is likely to play out in the world's biggest economy. O'Neill also expects the size of rate increases in the United States to be smaller than the 290 basis points of tightening typically seen in every cycle since 1994.

His view is not an outlier. Markets are pricing in an end-2016 Fed funds rates of less than 2 percent.

The implied structure of 5-year U.S. yields in the 5-year forward market is pointing to an average future yield of 4.3 percent, compared with the spot 10-year Treasury yield of 2.9 percent.

Bill Gross, co-chief investment officer of Pimco, has said that the Fed Funds rate may not increase at all in this decade.

And it is this relatively benign view of the rate horizon that partly explains why Wall Street stocks zoomed up more than 30 percent last year to records even as the Federal Reserve flagged the ending of its extraordinary monetary stimulus.

In early 1994, when a build-up of inflationary pressures prompted a surprise Fed rate hike, the consequent 150 basis point jump in Treasury yields in about a month sent the S&P 500 index down 10 percent. Last year, 10-year Treasury yields jumped 130 basis points and Wall Street barely blinked.


So a tightening cycle may be just around the corner - but the impact on financial markets may not be so severe.

Higher nominal interest rates will push real interest rates - nominal rates minus inflation - higher, notably in Britain, which has negative real rates. Higher real interest rates attract investment, especially from corporates who have trillions of dollars of cash sitting on their balance sheet.

"Return on capital in the West is starting to rise," Michael Howell, managing director of CrossBorder Capital.

"The corporate sector in a lot of economies is rebounding very fast. They are sitting on a huge amount of cash that's going to be spent."

An obvious flashpoint will be emerging economies who are dependent on external funding, and smaller rate hikes by the major central banks would be a welcome help.

There is still strong investor appetite for high-yielding emerging debt, with Indonesia — one of the Fragile Five economies that are most vulnerable to tighter U.S. monetary policy — selling both rupiah and dollar bonds without a problem earlier this week.

"When the Fed does end its bond purchases, we believe the interest-rate differential will likely be in favor of emerging markets with high growth and inflation dynamics that should dictate higher interest rates than those in the United States," wrote Michael Hasenstab, portfolio manager of Franklin Templeton.

"We believe the relative value potential of these countries' assets is still intact as they have not been printing money; therefore the pace of Fed tapering is unlikely to have a fundamental impact on countries that continue to exhibit strong fundamentals."

Editor’s Note: 38 Trades That Could Turn $1,000 Into $49,000

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As the era of money printing draws to a close, the prospect of a cycle of rising interest rates over the next couple of years appears daunting for investors and households so used to cheap credit.
Investment,Interest Rate,Panic,Bonds
Friday, 10 January 2014 10:36 AM
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