The US Federal Reserve’s most recent minutes confirm the central bank’s accommodative monetary policy. However, while it left the target range for federal funds at 0.5 per cent to 0.75 per cent, the message is that rate rises this year are more likely than not.
Conversely, the Reserve Bank of Australia’s rhetoric suggests its rates are on hold.
Clients can benefit when central banks have divergent approaches but there are risks as well. It’s up to advisers to ensure they understand how global interest rate movements affect their portfolios and the opportunities and risks changes to rates present.
“Despite below-target inflation and a stronger Australian dollar, we expect the RBA to hold the cash rate steady at 1.5 per cent for all of 2017,” says Carlos Cacho, market and research analyst, Colonial First State Global Asset Management. “Recent comments from governor Phil Lowe suggest the RBA is concerned about financial stability, particularly the high and growing levels of household debt, and is unlikely to cut interest rates this year.”
There are implications across asset classes from central bank interest rate decisions, but rising bond yields are the main consequence of future US rate rises.
“Despite rising bond yields, deposit and term-deposit rates are likely to remain around [record] lows,” Cacho says. “So investors looking for reliable and secure income streams may need to review their portfolios to ensure they are appropriate for their goals and risk profile.”
Divergent interest rates create opportunities
While it’s important to be aware of risks, opportunities abound when markets experience opposing forces such as different interest rates across countries. For instance, the same asset class can produce considerably different returns, depending on the market in which it trades.
Cash is a good example. The return on Australian dollars is much higher than on US dollars, given our official interest rate is 1.5 per cent and the US’s is 0.5 per cent to 0.75 per cent.
“Investment managers who have the flexibility and mandate can take advantage of global mispricing of assets,” says Aman Ramrakha, executive manager research, wealth management advice, Commonwealth Bank. “One way to profit is through investing in the whole spectrum of asset classes.
“But it’s critical for clients not to be tempted into investing in higher-risk assets by the income on offer. Remember, any asset that increases your return also has a higher level of risk.”
Caution: rates may rise quickly
While the market is expecting future US rate rises to be broadcast well in advance, to cushion any negative impacts, one risk is that rates will rise faster than expected. Clients should be prepared for this.
Kyle Lidbury, head of investment research at Perpetual Private, warns stimulatory US fiscal policy and growth in demand may lead the Fed to increase rates faster than the market expects.
“There will be a knock-on effect as US bonds become more attractive in terms of relative yield, which will potentially increase rates on bonds globally,” Lidbury says.
As US rates rise, the casualty will probably be emerging markets, particularly those that can’t afford to borrow in their own currency and have a substantial exposure to US dollar-denominated debt. Their borrowing costs will rise as US rates rise, pushing down the performance of assets in these markets.
While investors expect rates to remain on hold when the Fed meets on March 15, there’s no guarantee this will be the case. Advisers would be prudent to prepare clients for a rate hike just in case, while acknowledging the central bank is likely to maintain the status quo, at least for this month, as is the RBA.
