Rising Interest Rates and the Impact to Investors
Central banks in various countries including Korea, Norway, NZ, the UK and Canada started raising rates in the last six months as economies recovered, labour markets tightened, and inflation surged in response to supply constraints. The Fed has been flagging the start of rate hikes for 2022 for six months and started warning of a move in March early this year after inflation kept surprising on the upside. So, the move was fully factored into financial markets with US shares actually rallying on positive Fed comments on US economic growth.
The Fed officials interest rate expectations has now moved up to seven 0.25% hikes this year from three in December and while the Fed sees uncertainty flowing from the war in Ukraine, its now more focused on controlling inflation, as it sees the US economy as strong.
The Fed also signalled that it will likely start Quantitative Tightening (i.e. running down its bond holdings – to be achieved by not replacing bonds as they mature) as soon as May.
Why the hike?
The reasons for the hike are simple and are the same as seen in other countries. Economic activity has recovered, the labour market is very tight with unemployment at 3.8% which is consistent with the Fed’s aim of maximum employment, inflation is at a 40-year high and core inflation is at 6.4% year on year and it’s still rising.
In summary, while the Fed’s move to raise rates is consistent with volatile and constrained share market returns ahead, it’s not necessarily consistent with an end to the bull market (or at least the start of a deep bear market) as monetary policy is far from tight and unlikely to be enough to drive a US recession. This is more of a risk for 2024 than for 2023 or 2022.
Risks
While past experience suggests little reason to be too concerned by the first US rate hike, there are two main risks:
What do rising interest rates mean for share market?
The impact of rising interest rates on equities is not clear cut and will differ from company to company. On one hand, rising interest rates typically means the economy is growing and demand is strong, which is a good thing for business in general.
For banks, higher interest rates can be positive and potentially lead to improved net interest margins (the difference between the rates at which banks lend and obtain funding). Higher interest rates also mean insurers can earn a higher yield on their investment portfolios, which include a significant allocation to cash and bonds, over time.
But rising interest rates can also mean a higher cost of capital going forward and higher discount rates, which could put downward pressure on company valuations. Much also depends on the actions of central banks (like the Fed and RBA) and governments and how effective they are at countering rising inflation while at the same time promoting economic growth. The near- to medium-term outlook for the share market therefore remains uncertain as participants grapple with key issues like interest rates and inflation, but also other concerns (with somewhat interrelated economic implications) such as Russia’s invasion of Ukraine, soaring commodity prices, and the recent rise of COVID cases in China.
Impact on Australian interest rates & the $A
The RBA will soon follow the Fed in starting to raise interest rates. We expect the first hike to come in June taking the cash rate to 0.25%, with three hikes in total this year taking it to 0.75% by year end. However, Australian interest rates are likely to rise less than US interest rates, which reflects lower inflation in Australia and the start of a downturn in Australian property prices, which will dampen the pressure to raise rates much.
While a decline in the short-term interest rate gap between Australia and the US normally puts downwards pressure on the value of the $A this is likely to be more than offset by strong commodity prices which is being accentuated by the war in Ukraine. As a result, unless there is a global recession, we continue to see the $A rising over the next year.
What’s next?
Investors should expect more interest rate rises in 2022. The Fed’s statement included that “ongoing increases in the target range will be appropriate”, while ASX cash rate futures imply several rate hikes before the end of 2022.
We should also expect continued volatility, as the market tries to guess how interest rates and inflation will play out. This can be disheartening when share markets fall sharply, however volatility can provide opportunities to buy at attractive prices.
Central banks in various countries including Korea, Norway, NZ, the UK and Canada started raising rates in the last six months as economies recovered, labour markets tightened, and inflation surged in response to supply constraints. The Fed has been flagging the start of rate hikes for 2022 for six months and started warning of a move in March early this year after inflation kept surprising on the upside. So, the move was fully factored into financial markets with US shares actually rallying on positive Fed comments on US economic growth.
The Fed officials interest rate expectations has now moved up to seven 0.25% hikes this year from three in December and while the Fed sees uncertainty flowing from the war in Ukraine, its now more focused on controlling inflation, as it sees the US economy as strong.
The Fed also signalled that it will likely start Quantitative Tightening (i.e. running down its bond holdings – to be achieved by not replacing bonds as they mature) as soon as May.
Why the hike?
The reasons for the hike are simple and are the same as seen in other countries. Economic activity has recovered, the labour market is very tight with unemployment at 3.8% which is consistent with the Fed’s aim of maximum employment, inflation is at a 40-year high and core inflation is at 6.4% year on year and it’s still rising.
In summary, while the Fed’s move to raise rates is consistent with volatile and constrained share market returns ahead, it’s not necessarily consistent with an end to the bull market (or at least the start of a deep bear market) as monetary policy is far from tight and unlikely to be enough to drive a US recession. This is more of a risk for 2024 than for 2023 or 2022.
Risks
While past experience suggests little reason to be too concerned by the first US rate hike, there are two main risks:
- inflation pressures are far more significant than at any time since the early 1980s and this may necessitate an even faster tightening in monetary policy than in the past.
- the war in Ukraine is a major source of uncertainty both in terms of adding to and extending the supply side constraints that are boosting inflation and posing a threat of weaker global growth – notably in Europe.
What do rising interest rates mean for share market?
The impact of rising interest rates on equities is not clear cut and will differ from company to company. On one hand, rising interest rates typically means the economy is growing and demand is strong, which is a good thing for business in general.
For banks, higher interest rates can be positive and potentially lead to improved net interest margins (the difference between the rates at which banks lend and obtain funding). Higher interest rates also mean insurers can earn a higher yield on their investment portfolios, which include a significant allocation to cash and bonds, over time.
But rising interest rates can also mean a higher cost of capital going forward and higher discount rates, which could put downward pressure on company valuations. Much also depends on the actions of central banks (like the Fed and RBA) and governments and how effective they are at countering rising inflation while at the same time promoting economic growth. The near- to medium-term outlook for the share market therefore remains uncertain as participants grapple with key issues like interest rates and inflation, but also other concerns (with somewhat interrelated economic implications) such as Russia’s invasion of Ukraine, soaring commodity prices, and the recent rise of COVID cases in China.
Impact on Australian interest rates & the $A
The RBA will soon follow the Fed in starting to raise interest rates. We expect the first hike to come in June taking the cash rate to 0.25%, with three hikes in total this year taking it to 0.75% by year end. However, Australian interest rates are likely to rise less than US interest rates, which reflects lower inflation in Australia and the start of a downturn in Australian property prices, which will dampen the pressure to raise rates much.
While a decline in the short-term interest rate gap between Australia and the US normally puts downwards pressure on the value of the $A this is likely to be more than offset by strong commodity prices which is being accentuated by the war in Ukraine. As a result, unless there is a global recession, we continue to see the $A rising over the next year.
What’s next?
Investors should expect more interest rate rises in 2022. The Fed’s statement included that “ongoing increases in the target range will be appropriate”, while ASX cash rate futures imply several rate hikes before the end of 2022.
We should also expect continued volatility, as the market tries to guess how interest rates and inflation will play out. This can be disheartening when share markets fall sharply, however volatility can provide opportunities to buy at attractive prices.