In the wake of last week’s interest rate hike by the US Federal Reserve and its admission of two more thisyear, investors, analysts and central banks around the world are shifting their policy stance and exposures in what could be the end of easy money.
Last week’s hike marked a pivotal point in economic history. Whilst you may not think a US rate hike may be that significant, it really is. It creates a massive knock on effect throughout the rest of the world. Firstly, raising interest rates has an immediate ripple effect with foreign currencies. The US dollar is used as a benchmark against its future economic growth. When rates go up, it’s usually followed by an appreciation in its currency. US Treasury Bonds are the first to reflect changes in rates. The Treasury yield curve will move up to reflect an increase in rate. Other securities must then offer a higher return than the risk free Treasury rate. This causes investors to shift their money into the US to take advantage of higher returns. In turn this causes the dollar to rise. Aussie dollar will fall. Currencies in emerging markets will fall. But it’s much more than just that. The rate hike pretty much marks the end of the rate cutting cycle. The days of easy money will soon be a thing of the past. Three rate rises since December 2015 and two more on the way have prompted major changes in interest rates around the world.
US Federal Reserve rate rising cycle
Here are some of the ripple effects caused by a change in the interest rate cycle:
US dollar denominated debt – Emerging markets Since the GFC, emerging countries have taken on loads of US denominated debt amassing some $3.3 trillion in just a few years. Countries such as Turkey, Ghana, Nigeria, Argentina, Brazil, Thailand, Vietnam, Brazil, and South Africa perpetually run trade deficits and finance their current account deficits by building up US dollar-denominated debt. When there is an interest rate hike together with a spike in the US dollar, you get a double whammy effect:the exchange rate between the emerging country and the US widens and the US denominated debt owed by the emerging country increases. The real risk here is that the debt becomes unmanageable. Not only does this occur, but it could also trigger a capital outflow where investors may shift money back to the US where rates are rising.
Falling currency – If the US raises interest rates while other global central banks maintain or lower their interest rates, then the return on savings is more attractive in the US than in other countries. This means capital flows from foreign countries to the US resulting in the dollar’s appreciation. This causes the exchange rate of other currencies to fall. It is good news for the RBA who won’t need to raise rates urgently with a falling Australian dollar. A US rate hike can be a pain for countries like China that will likely see an increased capital outflow. The outflow of capital from developing markets will in turn cause their currencies to depreciate further. When foreign investment into emerging countries starts to dry up it will effectively put the brakes on economic growth that relies on such investments. The countries most at risk of this are Turkey, Brazil, India, South Africa, and Indonesia. Australia’s cash rate is materially higher than the US rate. That makes Australian deposits more attractive so foreign investors will buy Australian dollars in order to take advantage of that “yield differential”.
US dollar denominated debt – Corporate As well as countries loading up on foreign debt, the same thing can be said about corporations loading up on US denominated debt driven by low interest rates. Easy money as it’s called. This debt now makes them vulnerable to future interest rate increases, resulting in higher interest repayments and rising debt levels. It’s a vicious cycle.
Australian banks – Mortgage & property market – When rates go up, it’s usually a headwind for the property market. Any increase in US interest rates would mean that wholesale bank funding costs go up. The big four banks get a third of their funding from bonds and the remainder from customer deposits. Therefore bond rates affect the cost of money for all of us. Banks can’t really offset the increase in wholesale funding costs with rates charged on deposits because they’re so low. So what do they do? They pass on the difference to customers by increasing interest rates independently of the RBA. Last week NAB increased rates. This week WBC upped its variable rate for owner occupiers by 0.03% to 5.32% on principal and interest loans. For owner occupiers paying interest-only they will see larger hikes of 0.08% and their rate climb to 5.49%. It’s quite simple, banks are borrowing too and they are simply passing this extra cost onto customers. In reality our banks have been itching to raise rates and this gives them the perfect excuse to do so. You can only expect more of these out of cycle bank rate rises independent of the RBA.
US 10 Bond Yield chart All assets are priced off bond rates either due to their yield differential or funding via debt.
But here-in lies the problem: Melbourne and Sydney have gone bananas with investors and home owners snapping up heavily overvalued properties that they can only barely afford. What happens when interest rates revert to the long term averages? One in five homeowners will get themselves into hot water if rates start to rise. People tend to think that property prices rise forever and interest rates will stay low for quite some time. Wrong. They’ll get a rude awakening when they find out this week that rates have already begun to rise. Australian household debt currently stands at a record 187% of income with average household net debt now sitting at almost $250,000. A case of ‘Buy now, Pay later’. Here’s how bad it can get. A 2.5% rise in interest rates would push mortgage repayments on average up by $6,223 per year. It would also push mortgage interest repayments to 58% from 42%. With higher mortgage rates on the way, it will cause financial stress for many that own a house. It will dampen demand, and almost certainly put off new investors. It will however be a welcomed relief for a seriously hot property market that needs demand to cool and for prices to come off the boil.
Lower commodity prices Many countries such as Australia are heavily reliant on commodity exports to support economic growth. Brazil and Russia depend on crude and gas prices, while Australia depends on iron ore and coal prices. There is usually an inverse relationship between commodity prices and the US dollar. So if the US dollar rises in value, commodity prices fall because they are denominated in dollars. When the dollar goes up, it means the commodities become more expensive for those who hold other currencies which has a negative impact on demand due to lower purchasing power and prices fall. Commodities are also traded in US dollars. So we could see further downward pressure on oil and gold. This is bad news for emerging markets because most commodities are in US dollars will generate less revenue in real terms. The Australian dollar is a commodities currency. That means it rises as commodities such as coal and iron ore rise. Iron ore makes up the bulk of Australian exports, so it’s little wonder that the Australian dollar is closely linked in to iron ore prices. Aussie ore must be purchased with Aussie dollars at the end of the day. As demand rises, so too does demand for the A$.
Stock Markets Rising interest rates are generally a headwind for stocks in the longer term but share markets do tend to climb for the first two years of a rising interest rate cycle. While there is no rule or definite correlation, in the past rising interest rates have spooked investors causing a sell off. There is an old Wall St adage ‘Three steps and a stumble’. That means watch out after the third interest rate rise, because stocks will fall. This is the third step, so we should see a stumble soon. The US markets is down 1.3% this week. We’ll soon know if the adage holds true. On the day of the rate rise both the ASX and Aussie dollar reacted positively. What the? Usually the rate rise would have seen the US dollar rise and Aussie fall. It could be that the absence of any surprise in the decision and expectations of three future rate rises that was pared back to just two, that may have caused the rise. Some even say that the false starts in September and October had many relieved that there was the hike and it was all priced in. Nevertheless, the norm is for higher US interest rates to put downward pressure on the share market because it becomes less attractive and the discount rate is higher.
The end of easy money The US rate rise marks the end of expansionary monetary policy and beginning of contractionary monetary policy. Expansionary monetary policy was used after the GFC to increase the money supply to lower unemployment, boost spending and stimulate economic growth. Interest rates tumbled to near zero. It worked a treat. Now it’s time to turn the tap off. Tightening monetary policy slows the rate of growth in the money supply in order to control inflation. The US economy is on a healthy footing as unemployment falls. As such rates need to rise to stop inflation from rising. What is for certain is that the 35 year old rally in the bond market is well and truly over. Whilst the interest rate cycle is definitely turned direction, it’s coming from a very low base and moving slowly. An article in the SMH talks about Macquarie conducting an investigation. The bank found that 18 previous Federal Reserve easing and tightening cycles since 1954 showed that rate rises particularly ones that occurred in the early part of the tightening cycle, were good for equities. Shares rose over 20% in the year after the first hike. Aussie shares rose during the start of a US tightening cycle at around 10% the following year. Going by that report, the start of a rate hiking cycle is a positive thing. However this is the third hike so the start of the rate rising cycle is maturing. Could it be that the next hike will see a market sell off?
Winners and Losers Winners – Banks stand to benefit from US interest rate rises as their net interest margin rises. NAB has already lifted its home loan rates citing increased wholesale funding costs in the bond market. NAB is expected to earn some $200m just from the increase. Westpac (WBC) has done the same with CBA and ANZ to follow suit. US rates also look favourably on QBE which is a winner from a rate hike. Why? Because QBE generates about a third of its revenue from the US and its portfolio is loaded with US bonds. So obviously a higher yield means higher returns. Tourism stocks such as Webjet (WEB), Corporate Travel (CTD), Mantra (MTR) and Sealink Travel (SLK) will benefit from a lower Australian dollar attracting tourists from overseas. Offshore earners such as Computershare (CPU), James Hardie (JHX), Ansell (ANN), Boral (BLD), CSL and Ramsay Healthcare (RHC) all benefit from a higher US dollar. Stocks in consumer staples, cyclical resources
Losers – It’s time to sell bond proxies. Income seeking investors bought companies that displayed bond market type qualities such as income and safety because bond yields were too low. As a result stocks like Sydney Airport (SYD), Transurban (TCL), APA Group (APA), Westfield (WFD) and Spark Infrastructure (SKI) saw increased demand as retirees bought these bond proxies for safe income. Telcos, infrastructure, pipelines, utilities and REITs were the main sectors. With bond yields on the rise, there will be a reversal of this bond proxy trade. As a general rule REITs, telcos and utilities all underperform in times of rising yields. Just by looking at the charts, you’ll see that these bond proxies have already started to pull back.They have to because they are sensitive to interest rate movements, demand high PE’s yet they trade on low ROEs. The best option is for retirees to switch back into fixed interest bond like investments or into cyclicals.
With easy money monetary policy now well and truly over, investors should adjust their portfolios in preparation for higher bond yields and interest rates. This means switching out of bond proxies and into cyclicals, offshore earners, banks and QBE. Goldman Sachs is forecasting the RBA to raise rates this year (November), which will more than likely be the catalyst for these bond refugees to start their exit. So why not get out before the herd exits? Well there’s one exception to the general rule: If Trump spends big on infrastructure, won’t that be positive for the sector? Whilst rising rates is usually a headwind for this asset class, the impact could be offset by Trump’s rebuild America will boost infrastructure related stocks. Despite this factor, Goldman Sachs says “With rates moving higher, bond proxies now look more expensive.” A 25% drop in bond proxy share prices wouldn’t be out of the question, if US 10 year bond yields rose to 3.83% from 2.5%. Whilst the general rule is – When rates are low, yields are hard to find, infrastructure stocks do well. The counter argument you may hear from some analysts is that most infrastructure companies such as Transurban (TCL) have assets that are inflation linked. So as interest rates go up, so does inflation which feeds directly into Transurban’s toll revenue which rises inline. Despite this, there will still be a sell-off as bond proxy investors worry about rising bond yields and switch. It’s a self-fulfilling prophecy. The other problem is rising rates makes it harder for these infrastructure companies to service their rising debt levels. In the end, investors hold infrastructure stocks because they’re rate sensitive. So when rates rise, these stocks will be sold for the same reason they were bought. They will usually pull back to their real valuations. Resources space are a good place to be. Think about switching into BHP, RIO, Alumina (AWC), South32 (S32), Bluescope Steel (BSL), QUBE (QUB) or Seven Group (SVW). Which-ever way you dice it, the days of easy money are over and the great bond market rally is now a thing of the past. Interest rates are set to rise and cheap money will now cost more. Safe haven bond proxy stocks such as infrastructure and property trusts might come under a bit of pressure as they lose their status.Bond yields are starting to rise not only in the US but worldwide. This ends a 30 year decline in yields. The Australian Government Bond has risen to 2.82% from 1.83% in August. The RBA has signalled that it will hold rates as is. No one is expecting the RBA to raise rates anytime soon, but next year it could become a reality. Our message to investors: Interest rates have already started to rise but are still low. You need to be ready to reposition your portfolio accordingly. Look for real earnings growth when selecting companies. An eventual rise will affect almost all sectors of the share market so remember ‘Three steps and a stumble’.