Goodbye interest rate cuts - hello hikes

Goodbye interest rate cuts - hello hikes

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Surprise hike proves inaccuracy of forecasts

The surprise rate hike in January 2014 marked the end of what has been the longest interest rate down-cycle in history. Up until then there were several false starts to rate hiking, each time unanimously and confidently forecast in the interest rate polls. January’s announcement of a 0.5% hike also caught economists off guard. This highlights the urban legend about the advice given by a veteran economist to “never make a forecast. If you are forced to, then never commit to a date. If you are forced to give a date, then never return to that audience.”

The interest rate up-cycle will be gradual

Even though the last protracted down-cycle was notably shallow, it still bottomed at the lowest rates in over 40 years, as shown in the chart. After keeping rates on hold in both March and May this year, it appears as if the inevitable up-cycle will at least be gradual. Capital markets are pricing in a 1% rate increase in a year’s time, while Nedgroup Investments’ Best of Breed™ cash manager, Taquanta Asset Managers, expects rates to peak at around 1.5% higher than current levels by the end of 2015. According to the South African Reserve Bank (SARB), interest rates are currently too low and must be normalised. However, the SARB will manage this normalisation responsibly in the context of the tough prevailing economic conditions.

Rising rates are an inevitable part of the economic cycle

The interest rate cycle is a phenomenon that is here to stay, because central bankers will continue to use interest rates as a tool to regulate the economy. Although the shape of the cycle will vary, rising rates are inevitable during certain periods. These hikes need not be a bad thing. In fact, markets absorb small, anticipated hikes in their stride. On the other hand, sharp, unanticipated and significant hikes can cause major disruptions in markets. Fortunately, it is unlikely that these kinds of hikes will happen in the context of the sound process followed by the SARB and the Ministry of Finance.

Investors should plan for regular rate hikes

Many investors were not in the markets during the last up-cycle and for those who were, many have forgotten what it is like to invest in a rising rate environment. Once the hikes begin, it is very likely that any central bank will continue to raise rates, although the pace does not have to be as aggressive as in previous cycles. Also, the magnitude of each hike does not have to be 0.5% each – there has been talk of 0.25% hikes this time around. Governor Gill Marcus reiterated in her recent announcement that, although rates were left unchanged due to the much weaker growth outlook and reduced threat from inflation, we are still in a rate hike cycle. It is the same scenario as a doctor prescribing a course of antibiotics. The patient must complete the course for it to have the desired effect, even if they start to feel better in the interim, otherwise the whole exercise may be futile. In the same way, South Africans should expect rates to continue to rise and adapt their fixed income investment approaches accordingly.

Actions that portfolio managers may consider in a rising rate environment

- Immunise the portfolio against rising rates:

This is one of the most important protective measures you can take. According to Taquanta Asset Managers: “The simplest way of immunising an income portfolio is to hedge out the future effects of any rate hikes, either using derivatives to swap fixed rates for floating rates or to hold very high levels of floating rate instruments in the portfolio. By doing this, the portfolio yield can adjust upwards in reaction to the rate hikes fairly quickly – usually within a three-month period, as the three-month Jibar-linked interest rate swaps or floating rate asset coupons adjust to the higher rates.”

- Review the portfolio from a sector and industry point of view:

The aim should be to lighten exposure to areas that may benefit less from a rate hike to those that would offer better risk-adjusted returns over the medium term.

- Hold more cash:

However, this can cause quite a drag on performance, especially if the SARB postpones the rate hikes.

- Do not to take on more debt:

This is because repayments will increase in a rising interest rate environment. Also, reduce debt where possible, as rising interest rates means higher interest payments.

Rate hikes provide promising opportunities

Locking into lower historic rates will result in an opportunity cost of potential interest and possibly even capital losses on the value of longer-dated fixed rate instruments. However, investors in pooled investment vehicles like the Nedgroup Investments Core Income Fund, will enjoy the benefits of the rising rates as the yield of the portfolio rapidly adjusts to market yields, without having to lock in their money for fixed periods. One benefit of the higher rates is that it will hopefully reduce the dangerous pastime of yield-chasing brought about by the low rates of the past few years.