Lost And Found

The rally in stocks and bonds over the past years has been driven by rock-bottom interest rates. But US long-term rates hit their highest levels in almost a year last week, and you’ll need to be careful this change in direction doesn’t send your portfolio off track.

 

🕰 Recap

  • In March last year, the Federal Reserve cut the key short-term interest to near-zero to keep the US economy going.
  • In December, Norway became the first major currency-holder to say its economy would be strong enough to raise rates sooner than it thought.
  • And in January, Democratic victory in the US senate elections increased the likelihood of additional government spending and, in turn, rising inflation.

 

✍️ Connecting The Dots

The recent rally in global stock markets fizzled out last week, mostly due to investor concerns about a potential rise in interest rates. And while you might think discussions on interest rates are a tad boring, rate moves – or even the anticipation of a move – have a decidedly un-boring effect on your investments.

Let’s start at the beginning: the world’s central banks moved to keep their respective economies ticking over during the pandemic by lowering short-term interest rates. That encouraged more borrowing – and consequently more spending – from companies and individuals alike. Lower rates have pushed investors toward stocks too: they tend to flock to them in hopes of higher returns when they’re not earning much on cash or bonds. But the reverse is also true: returns on cash and bonds look more attractive when investors think interest rates will rise, and share prices could fall if those investors then cut their stock allocations – just like in 2018.

And the thing is, the prospect of higher interest rates no longer looks as theoretical as it did even at the start of the year. Investors think more government borrowing and an economic recovery are on the way, which has likewise increased their expectations that the prices of goods and services will increase (i.e. inflation). And if prices climb by too much, too quickly, central banks might hike interest rates to slow spending down.

In fact, the belief that the central banks will take their foot off the gas to prop up the economy has caused the US 10-year bond yield – the key long-term US interest rate to watch – to rise from below 1% at the end of January to 1.3% last week. That’s its highest level in almost a year, and that fact wasn’t lost on investors: stock markets faltered.

 

🥡 Takeaways

1. Here are the winners to back when rates are on the rise. 

Any period when interest rates are expected to rise tends to be a period of economic recovery. So you might not be surprised to find out that the stocks that tend to do well when interest rates rise are economically sensitive “cyclical” stocks, like industrials and banks. Speaking of which, bank profits also stand to benefit from the wider gap between what they charge borrowers and what it costs them to borrow from central banks.

2. Commodities are one of the best protections against inflation.

As prices of goods and services increase, so do the prices of the materials used to produce them, which is why commodities are thought to offer a good “hedge” against inflation. What’s more, the supply of commodities often struggles to keep up with demand, which drives prices even higher. As for which ones will do the best: industrial commodities like copper should prosper in an economic boom, thanks to their widespread use in infrastructure projects.

 

🎯 Also On Our Radar

The British pound hit its highest level in three years against the US dollar, as the UK’s rapid vaccine rollout gets investors thinking that herd immunity could drive a swift economic recovery. And it’s not just the currency that will profit from an economic boom: British stocks could get an extra boost too.

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