Imagine you’re pumping up a balloon. The further you push down on the pump, the larger the balloon inflates. When you pull up on the pump, the balloon starts to shrink.

The relationship between interest rates and financial assets is very similar. Falling interest rates and yields – pushing down on the pump – increases the prices of financial assets: the balloon.

But markets are now fretting that the pump is about to be pulled back up again: and the impact on financial assets could be significant.

Understanding interest rates can be quite technical but the broad points, as we show here, should be easily understood.

Which interest rate?

Central banks set very short term interest rates. In July, the Bank of England cut its main interest rate to 0.25%. So why are investors worried about increasing interest rates when the Bank of England is actually cutting them?

While the central bank sets short-term interest rates, longer-term interest rates tend to be decided by investors and markets – and it is these interest rates which are rising.

Long-term interest rates are best understood as the market’s expectation of where the Bank of England interest rate will be in the future.

Typically, changes in yields on government bond markets are where these expectations are expressed.

Ten-year government bond yields have increased to 1.43% from 1.08% in the last month. Very simply, this market movement means investors believe that the Bank of England will need to raise interest rates more quickly in coming years than was assumed one month ago.

Rising government bond yields mean investors expect one or a combination of factors to play out:

• Higher economic growth;

• Higher inflation; and,

• Higher chance a government fails to repay its debts.

The key point to understand is that government bond yields are the market’s best guess on the future direction of interest rates. Recently that best guess is erring towards higher rather than lower interest rates, albeit from a very low base.

Interest rate impact

When government bond yields rise, the prices of government bonds fall – just like in the example with the pump and the balloon. It also means the prices of other similar assets are likely to fall too – for example corporate bonds.

Certain types of companies listed on the stock market are also like bonds and their share prices behave in a similar way. Utilities are a good example. Not only are their profits very consistent – like the coupons paid on a bond – they also pay out a large share of these earnings as dividends.

Utilities and stocks like them are often described as ‘bond proxies’ – they are stocks which trade like bonds. Bond proxies have been great assets to own over the last three decades because ‘the pump’ has been pushed further and further down: Bank of England interest rates fell from 17% to almost zero in that period.

If, as markets expect, interest rates rise more quickly, companies that produce consistent but slow growing profits like utilities might struggle. If markets are wrong and interest rates fall there is probably some upside in bonds and bond proxy assets like utilities.

Elsewhere, there are some opportunities from rising bond yields. As we saw earlier, interest rates rise when investors expect higher economic growth, higher inflation or a higher chance of government insolvency.

Cyclical Recovery

Higher economic growth should mean improvements in profitability at companies which are sensitive to the economic cycle. Higher profitability usually means higher share prices. Shares covered a few examples of companies which potentially sit in this bucket in last week’s edition. Construction companies, industrials, some consumer businesses and banks could be beneficiaries.

Increasing inflation without economic growth is a much more difficult environment in which to invest. Gold miners are typically seen as a hedge against inflation, though it is worth noting the value of London-listed gold stocks have been falling rather than rising in recent months. Industrial metals have done better however, including companies like copper miner Kaz Minerals (KAZ).

A higher chance of government insolvency is another reason why interest rates may rise. Governments like the UK and the US, which issue their own currency, can usually find a way to repay their debt. Countries in the eurozone, however, do not have this option and this is why yields on Greek government debt, for example, came close to hitting 40% in early 2012.

Overall, it’s important to understand why interest rates affect stock prices and the factors which may offset them like higher growth at certain companies. Whether interest rate expectations rise or fall in the next 10 years, investors should try and understand how much risk they are taking and consider what, if anything, they can do to build a diversified and resilient portfolio.

‹ Previous2016-12-01Next ›