By Paul Rickard
Don’t be fooled by reports that the Reserve Bank has gone soft on the idea of future interest rate increases. As Governor Philip Lowe makes clear in his statement, the Bank is worried about the current strength of the Australian dollar.
“The outlook continues to be supported by the low level of interest rates. The depreciation of the exchange rate since 2013 has also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment.”
With the currency over 76 US cents, the Bank couldn’t afford to give any hints that it is contemplating an increase in interest rates - yet. But in an environment where the rest of the world has commenced a tightening cycle - the US has now had four rate increases and higher rates are seriously on the agenda in Canada and the UK - it is inevitable that Australia will follow suit. It may not happen until 2018, but it will happen.
Moreover, the bond markets are telling us that it is going to happen. Over the last week and a bit, 10 year US Treasury Bonds have jumped from a yield of 2.13% to 2.33%. In Australia, our 10 year Government Bond has risen from a yield 2.35% to 2.62%.
US 10 Year Government Bond Yield
Australian 10 Year Government Bond Yield
The yield on the two year US Government bond has reached its highest level in many years at 1.41%, while the yield on the two year Australian Government bond has risen from 1.65% to 1.79%.
Importantly for share investors, bond markets appear to have resumed an uptrend in yield. Recovering from a multi-decade low, the uptrend accelerated with a frenzy following the election of President Trump in November. This led to a major shakeout in the equities markets, and while global markets in aggregate rose, there were a number of losers as investors switched out of interest rate defensive stocks. Yields subsequently retreated and prices on the defensive stocks rallied, but already, a similar pattern is starting to emerge following this latest uptick in bond yields.
Winners from higher bond rates
In theory, increasing interest rates should be bad for stocks. Higher interest rates means that the cost of servicing borrowings by companies increases and as result, profits decrease. Further, consumers delay or put off discretionary spending, leading to lower economic growth. Historically, rising interest rates have been accompanied by bear equity markets.
This time, the markets believe it is different (at least initially), because interest rates are still essentially at emergency levels. They can go up a couple of percent or so to “normal” levels without having too much impact on the economy. Moreover, they signal in the short term that economic growth is picking up and that a little bit of inflation is coming into the system.
Winners include the cyclicals that benefit from higher economic growth, and potentially even resource companies like BHP and Rio who stand to gain from increased demand for hard commodities. The other major beneficiaries have been the financials (banks and insurance companies).
While in the long term higher interest rates will be bad for banks due to an inevitable increase in loan losses and bad debts, in the short to medium term, it is a positive because they should be able to increase their net interest margin. Most banks have a large volume of 0% or near 0% deposits (for example, cheque accounts) that they can’t or rarely change the deposit interest rate paid. If benchmark interest rates go up, they can pass on the higher charge to their borrowers, but don’t need to pay a higher rate to these 0% depositors. Consequently, the net interest margin for the bank improves. The converse occurs when rates fall - bank margins are squeezed.
For insurance companies such as QBE, it is about the investment return on their reserves, which goes up if bond yields increase.
Losers from higher rates
Losers from higher interest rates are companies that are highly-geared. Interest costs will go up, so profits will decrease.
The other major category is the so-called “interest rate” defensive stocks. These companies have annuity style characteristics with predictable (and often regulated) income returns, and are sometimes viewed as “bond substitutes”. When interest rates fell to near 0%, the prices of these stocks were bid sky high as investors chased their very predictable and relatively high distribution yields. With interest rates rising, they are relatively less attractive, so prices fall. Examples include the property trusts, utilities, and companies such as Transurban and Sydney Airport.
Interestingly, these stocks have already started to move. As a sector, property trusts were down 4.4% in June (income and capital), while utilities dropped by 2.7%. Transurban has dropped 10.4% since 20 June, from a high of $12.945 to yesterday’s $11.60. At the peak of the frenzy last November when 10 year US bond rates hit 2.60%, Transurban fell to a low of $9.45. Another bond proxy, Sydney Airport, is down 8.5% since 26 June.
Gold is also a loser, as the zero income return becomes relatively less attractive (more expensive to hold). Where gold goes, the gold miners such as Newcrest and Northern Star follow.
How to position
Because the US leads and the rest of the world follows, US treasury bonds hold the key to how components of the market will perform. My guess is that we will see further weakness in the interest rate defensives in the short term.
Back in November, US treasury yields topped out at around 2.60% - so this will be a key level that the market will watch. If this level holds, then the equities markets will switch their attention to other matters, such as the upcoming earnings seasons (in the UA and in Australia). If it breaks, then we could be in for a whole different ball game.
Fixed income investors are probably best advised to keep their duration short, while term deposit investors may want to keep rollovers to less than nine months.
Bottom line - watch the bond market.
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