How to Play Rising US Interest Rates

Friday’s non-farm payrolls report in the US gave the Fed another excuse to raise interest rates next month. The US economy created 271,000 jobs in October, well ahead of expectations.

It was the fastest pace of jobs growth in over a year and the fastest wages growth since 2009. The US unemployment rate — at least according to official measures — is now just 5%. And interest rates are still zero!!

A December interest rate rise now looks very likely. The Fed has run out of excuses. The only thing that would make them pause would be another bout of ‘risk-off’ trading in financial markets. That is, falling stock prices.

The Fed has a dual mandate. Their role is to foster jobs growth with a stable price backdrop. But the Fed has a third, unofficial mandate too. It’s to protect stock prices. So the only impediment to an imminent rate rise is global financial market instability between now and mid-December when the Fed next meets.

If the market thinks the Fed is behind the curve, then one interest rate rise won’t really matter, not for US stocks anyway. But you have to keep your eye on emerging markets. This is still the most likely source of financial turmoil.

That’s because the US dollar is surging again. A strong US dollar means that all ‘non-dollar’ assets — gold, oil, commodities, emerging market currencies, etc. — fall in value.

The US dollar index gained a very strong 1.23% in Friday’s trading session. You can see in the chart below that it closed at its highest level since April. The upward trend remains intact.

Source: StockCharts

[click to open in new window]

This spells danger for all those emerging market economies holding large amounts of US debt. Remember, during the post-2008 low US interest rate years, emerging market companies borrowed trillions of US dollars on the assumption that interest rates wouldn’t rise.

But now a rise is on the cards. And as the US dollar increases, the foreign currency debt burden grows. That’s what the August stock market scare was all about. At the time the market feared a September rise from the Fed. Many emerging market currencies were under pressure.

At the time, China devalued the yuan on a number of occasions and this lead to a panic amongst global speculative capital. The Fed helped to calm to panic by delaying interest rate rises, and it worked. Markets bounced back strongly.

But here we are again, potentially a month away from a rate rise. Can the markets handle it?

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I said last week that US markets were due for a correction after such a strong bounce back. I still think that will be the case. But the depth of any correction will be important to monitor. If it’s a shallow one, it’s telling you the market is ok with the prospect of rate rises and new highs might not be too far away.

But if stocks head back down to the August and September lows, then it’s a sign that the global economy just can’t handle higher interest rates from the Fed.

As of Friday, the market looks like taking a rate hike in its stride. Rising rates reflects a ‘strong’ economy after all…if by strong I mean an economy juiced up on years of monetary stimulus.

While stocks remained steady on Friday, US bonds fell heavily. This is another vote for growth, as bond yields usually increase when growth prospects pick up. Or maybe it’s just a concern about the prospect of inflationary pressures at 5% unemployment at near zero interest rates.

What’s the best way to play this then?

Firstly, I think you need to be wary about assuming that this is the start of a trend. Markets are incredibly complex and no one knows whether the world can cope with higher rates right now. That’s why the Fed has been so reluctant to move.

So what seems like a trend can quickly turn around.

From as asset allocation perspective, the lowest risk option is to remain diversified. Don’t bet heavily on any outcome. That means you hold cash, gold, stocks and bonds. You can diversify cash by owning a range of different currencies. You can diversify your bond holdings via a range of managed funds, and if you’re a direct stock investor online platforms offer easy access to international shares these days so diversification is easy there too.

Gold is gold. Think of it as your financial insurance policy. There’s no need to diversify. It’s just a question of ‘how much’. Jim Rickards, editor of Strategic Intelligence, reckons 10% as a minimum.

Although based on the reaction of the US dollar gold price on Friday, financial insurance is for losers. It fell over US$20 an ounce on the release of the strong jobs number.

When no one wants financial insurance, at least you know the premiums are cheap.

The good news for Aussies investing in gold is that the Aussie dollar copped it on Friday as well. So gold priced in Aussie dollars barely budged.

The financial insurance angle works for gold a bit better when your currency is weak. And the Aussie dollar is certainly a weak currency. That trend is likely to persist into 2016.

That’s because China will continue to transition away from its steel intensive economy, which will continue to knock down the value of our most important export, iron ore.

In fact, data released this weekend provided more evidence of a slowing Chinese economy. From the Wall Street Journal:

China’s General Administration of Customs said October exports fell 6.9% year-over-year in dollar terms, after a drop of 3.7% in September. The October figure was worse than the median 4.1% decline forecast by 11 economists in a survey by The Wall Street Journal.

Imports in October fell by a sharper-than-expected 18.8% from a year earlier, following a 20.4% decline in September. China’s trade surplus widened in October to $61.64 billion from $60.3 billion in September.

As this slowing China theme continues into 2016, it will make it harder for Aussie stocks to perform well, or at least keep pace with northern hemisphere markets. The ASX is bank and resource stock heavy. Neither is likely to do well in the current environment.

So if you haven’t already, seriously consider increasing your diversification to include international assets and/or non-index hugging Aussie funds. It could make 2016 a better year.


Greg Canavan

For Markets and Money

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Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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