PWL Capital September 22, 2016 Advanced Investing Market Research Does Hiking Interest Rates Damage Your Wealth? Should we fear rising interest rates? The hiking in question is not in reference to outdoor pursuits but the impact of interest rate changes, especially ‘hikes’, on bond and equity returns. Our title is borrowed directly from an article that studied the impact on investor returns when central banks change short term interest rates. After a decade of falling interest rates, reaching a level that was the lowest since the US Federal Reserve was established in 1913, rates were increased in December 2015. Further rate hikes are widely anticipated, although the pace of further increases is uncertain. What are the implications for investors? Central banks change short term interest rates as a means of controlling inflation. Higher interest rates means higher borrowing costs for individuals and businesses, which decreases consumer spending and reduces pressure on prices. What does the historical evidence tell us about the impact of changing interest rates on investments? The authors of the aforementioned study reviewed data across 21 countries spanning 116 years and we explore their main findings below. The study first examined the short term impact of interest rate changes to address the question of whether there is an investment advantage to correctly anticipate a rate change. This is a more nuanced question that it first appears. Central banks have no desire to cause surprises that lead to market volatility and go to considerable efforts to signal their intentions in advance while retaining an element of “wiggle room”, should the unexpected happen before an announcement. Bond and equity markets incorporate these signals into market prices, so that markets only react to the surprise element of a rate change. The study concluded that central banks (at least in the US and UK) have been quite successful at allowing markets to adjust prices in the 20 days in advance of an interest rate change, so that impact on the announcement day is small. Longer term the impact was more significant. The conventional expectation is that interest rate rises are bad for stock and bond prices. As noted above, higher interest rates decreases consumer spending and lowers corporate profits. The price of a stock is strongly influenced by future profits, so a decline in profit expectations leads to a fall in current stock prices. Although central banks can only change short term interest rates directly there is the expectation, all other things being equal, that successive short term rate increases will feed through to longer term borrowing costs. Higher long term borrowing costs means that a new borrower has to be willing to offer a higher interest rate than offered previously. This drives down the price of existing bonds until the yield and capital gain from these bonds matches the increased yield from new issues. The review across 21 different countries at least partially confirmed conventional wisdom: on average there was an 8.4% difference between real (i.e. after deducting inflation) stock returns in the year after interest rates fell compared to when interest rates rose. As the study notes, the impact of rate changes was negligible for the US and the UK and this may be the trend in other countries as they mature and global economies become more inter-dependent. One possible explanation is that investors in developed economies such as the US learn to view rate rises as an indicator that central banks see a strongly growing economy, which is good long term news for stock returns. A similar analysis for bonds showed that, across all countries, real bond returns were 1.5% higher in years following rate falls compared with years following rate rises. Again, the impact on US bond returns was negligible and both the UK and Canada showed the opposite trend: real bond returns were higher following a rate increase. The results from the study suggest that most of the impact of a rate change is incorporated into market prices before the event and central banks are motivated to avoid surprises. Trying to anticipate the short term impact is therefore about trying to anticipate surprises, yet the impact of surprises seems small. Unless investors can claim some special insight into the intention of central bankers and be better than the market at avoiding being surprised, there is nothing to be gained from anticipating central bank actions. In the year following rate changes, the bulk of evidence suggests that investors in both stocks and bonds experience lower returns in a rising rate environment, although the US provides an interesting exception. Lower returns are not necessarily negative returns, so there is no suggestion that investors should abandon stock or bonds in a rising rate environment. Share: Facebook Twitter LinkedIn Email