Saturday, May 31, 2008

Interest Rates - Is the cycle turning?

Over the last 12-18 months Hong Kong investors have been beneficiaries of interest rates that started at modest levels and became progressively cheaper. This had implications for both affordability levels and asset valuations. Property prices rose steadily as interest rate falls. Certainly there were other factors which contributed to the bull market, but interest rates falling to levels materially lower than the rate of inflation unquestionably played their part.

With inflation now commanding space on the front pages of the financial news, there is talk of interest rates rising due to a combination of central bank action to combat inflation (although avoiding recession is likely to remain a higher priority) and lenders using inflation as a pretext to inflate their lending margins. The yields on investment grade debt securities have started rising already. Expectations of further interest rate cuts have dwindled sharply. It would be unrealistic to expect interest rates to fall further (and if they do, there is only limited room for cuts anyway) and the possibility of increases in interest rates by year end is quite real.

What are the implications for investors?

Rising interest rates should create a headwind for investors in real estate and equities. I say "should" because there is at least a possibility that rising interest rates signal the US economy moving away from the edge of a recession. Bonds will of course be an investment to avoid when interest rates rise. I have no idea what commodities would do in a rising interest rate environment but it would be reasonable to assume that at least some money will be rotated out of that sector. The safe or default strategy in an environment where interest rates are rising would be to focus on deleveraging the portfolio and wait for asset values to come under pressure before buying again. Of course, if the increase in interest rates is only small and real interest rates remain negative then paying down debt is logically a poor strategy but if the values of the major asset classes all enter into a downtrend, there may not be any obvious alternatives.

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