It’s finally here. The time when central bankers warm up to lifting rates from their historical lows.
I’ll let the Australian Financial Review set the scene:
‘Global central bankers are coalescing around the message that the cost of money is headed higher – and markets had better get used to it.
‘Just a week after signalling near-zero interest rates were appropriate, Bank of England governor Mark Carney suggested overnight that the time is nearing for an increase.
‘His US counterpart, Janet Yellen, said her policy tightening is on track and Canada’s Stephen Poloz reiterated he may be considering a rate hike.
‘The challenge of following though after a decade of easy money was highlighted by European Central Bank president Mario Draghi’s attempt to thread the needle.’
Get ready for more expensive stocks. I say this because many investors use the discounted cash flow method to select their investments. Therefore if interest rates increase in the long-term, the discount rate applied to stocks also increases.
So does this mean everyone’s going to flood into bonds as yields increase and share market valuations become too high to bear? Maybe not.
An interest rate increase could make bonds more appealing
As interest rates rise (central banks buy less government bonds), bond prices fall, causing the yield on bonds to rise. And because AAA bonds are seen as risk free, the higher the yield, the more attractive they are.
However, fixed income investors aren’t too confident on the direction of long-term yields. The consensus is that yield will be higher 10 years from now, but by how much?
Take a look at the US treasury yield curve below.
The yield curve plots yield of government debt going out in maturity. Therefore, it can give you some idea of what investors are expecting interest rates to do in the future.
On the graph above, the green line is the current yield curve. The brown line is the yield curve from one month ago. The bar chart below is the difference between the two.
As you can see, short-term expectations are higher than a month ago. But for long-term yield (10-30 years) expectations are lower.
This could be due to the fact that investors don’t share the Federal Reserve’s expectations on growth. Some even believe the Fed is only raising rates now to be able cut them when we really need monetary stimulus.
Stick to your guns
While short-term yields are rising, I wouldn’t recommend you jump into bonds. For one, stocks provide far more attractive returns than bonds. Sure, they carry more risk. Yet, if you’re careful about your investment selection and buy stocks which are temporarily cheap, I assure you you’ll be surprised with the risk adjusted returns you get.
As for this ‘stocks go down when interest rates rise’ business, it’s not always true. As Michael Foster explained in Forbes:
‘In the early 1980s, interest rates doubled from their 1978 levels over a few years—and the stock market rose 50% at the same time.’
This wouldn’t mean much if real interest rates were flat or even declined over the same period. Unlike nominal rates, the real interest rate takes inflation into account.
For example, if inflation is 2% annually and you earn 3% on a term deposit, the real interest rate you receive on your investment is 1% (3% – 2%).
Yet from 1978-82 real interest rates also more than doubled. Foster continues:
‘Then in the late 1980s, rates rose swiftly, and the market stayed roughly flat [so too did real rates]. ‘What makes this even more fascinating is that America suffered a recession at this time because of the Federal Reserve’s restrictive monetary policy. By the time the recession ended, stocks were over 20% higher.
‘The bottom line? The tired refrain that rising interest rates hurt stocks needs to die.’
Junior Analyst, Markets & Money
PS: A big reason to invest in blue chips is for income. They offer big dividends, and usually pay out large portions of profits to shareholders.
However, it’s not always the blue chips that have the best dividend yield. Income specialist Matt Hibbard has written a new report — ‘Top 5 Dividend Stocks in Australia for 2017’ — all about the best Aussie dividend stocks.
Some of the stocks Matt mentions pay reliable yields of 6%, 7%, 8% and more. That’s more than 5% what you’d get on an Aussie 10-year bond for just slightly more risk.
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