Interest Rates have been front of centre of the economic and political dialogue globally for the past year and beyond, both domestically and globally. In this note, we examine the drivers of rates and provide unique insights into how we view the impact on asset class returns of interest rate changes.
The Yield Curve: the market for interest rate expectations
In quantifying the market’s expectations for interest rates into the short, medium and long term, the yield curve is an essential guide to a shifting rate environment. This is because the yield curve reflects the expectations of the market in aggregate in terms of where interest rates are headed. In the chart below, the 10-year yield implies that the market currently expects an interest rate of around 1% to lend to the Australian government over that timeframe.
The plot below is of the Australian Government yield curve, versus its position one year and five years ago. The yield curve is dynamic and is re-evaluated on a continuous basis, driven by buying and selling activity and prices of Australian Government bonds of various maturities and characteristics.
The graph below shows how interest rates of all maturities have collapsed, both from 5 years ago (grey) and steeply from one year ago (orange).
As you can see from the chart above, expectations of rate rises have moderated over the last 12 months (As of 12th August 2019).
Asset Class Implications
The collapse in the yield curve is an issue of current paramount importance to asset allocators.
As part of our decision making, we put together a simple ready reckoner on the impact of falling rates on asset classes, and sub-sectors. When considering the impact of changes in rates, there are two key drivers to consider:
1) The “Rate Sensitivity”: the value of the asset today is a discounted sum of future cashflows. The value of the asset therefore increases as the discount rate falls.
2) The “Growth Sensitivity”: a drop in rates implies a deteriorating economy. “Growth” assets with a high dependency on economic activity tend to suffer most.
In the table below we rate the return impact of a drop in rates from both a “Rate Sensitivity” perspective, and a “Growth Sensitivity” perspective. ‘++’ suggests a strong positive return is expected if rates fall, ‘0’ suggest no impact, ‘–‘ suggests a strong negative impact.
The reverse effects are true in the table above if it proves that interest rate rises are now less likely, or are likely to be pushed out.
Interest rates are just one very important variable likely influencing portfolios over the medium to long term. It is also worth remembering that this effect is only one variable of many that are likely to play out. Changes in interest rates are also in the context of the global macro-economic environment, and this will inevitably include prospects for all the major economies, particularly the US and China, commodities, the Australian Dollar, credit market conditions, and so forth.
Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.
Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.