How would an interest rate rise impact my investments and should I do anything to protect them?
Ahead of the US Federal Reserve's (Fed) interest rate decision later this week, Keith Wade looks at interest rates from a UK perspective and how investors can prepare for when the Bank of England opts to hike.
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UK rate rise on the horizon
The Bank of England is edging toward an increase in bank interest rates.
After more than six years of rock bottom rates, the latest minutes from the Bank of England’s rate setting monetary policy committee indicated that higher rates are likely, probably early next year.
This followed a warning earlier in the summer from the Bank of England Governor, Mark Carney, when he said that the cost of borrowing money may have to move higher sooner than expected.
For savers this will come as a relief as it holds out the prospect of finally being able to get a better return on cash.
Not only have interest rates been low, but they have been below inflation for the past six years so that savings have been effectively rusting away in terms of what they will buy in the future.
So should savers start to move back into cash in anticipation of better returns?
Periods of rising interest rates are often associated with volatile stock and bond markets and the case for becoming more defensive is given added impetus when we look across the Atlantic and see that central bankers in the US are also preparing to raise rates.
It is often said that the US Federal Reserve sets the global cost of money so any tightening there will echo around the world.
However, before we sell up and return to cash we need to recognise that rising rates in the UK and US would be a sign of economic progress.
The UK grew at a healthy 0.7% in the second quarter of this year, the ninth consecutive quarterly gain since the economy turned at the beginning of 2013.
Unemployment is returning to its pre-crisis rate and output is now some 5.5% above the level when the financial crisis struck.
From this perspective action by the Bank of England will be confirmation that the economy is getting back to normal and no longer needs to set interest rates at their lowest levels for more than 300 years.
The story is the same in the US: a rate hike by the Fed will be a step on the path toward recovery after the financial crisis: emergency level interest rates are no longer needed.
Is a rate rise good or bad for investors?
When we look at the performance of markets during interest rate hiking cycles it is important to make this distinction between times where rates are rising in response to stronger growth, or when the central bank is responding to an economic problem such as overheating or a currency crisis.
Not surprisingly, markets do better in the former as investors look ahead to better growth rather than an impending recession.
The Bank of England has no reason to squeeze the economy as inflation is well behaved and meanwhile the pound is firm on the foreign exchanges.
Consequently, we would remain positive on markets as interest rates are gradually pushed up.
Are we being too complacent?
After so long without a rate rise there are fears, voiced by some at the Bank of England, that the economy will simply keel over at the first hint of higher borrowing costs.
There are even worries that we might enter another ‘Great depression’.
However, the tightening of lending criteria by the banks during the crisis means that the economy should be more resilient to rate hikes in the future, not least because UK households are less extended and more able to meet their mortgage commitments.
This argues for a slow and gradual tightening, rather than no tightening at all.
So against this backdrop what should investors bear in mind?
If rates rise in the way we expect then there is no need to rush into cash.
On our forecasts UK bank rate will not reach 2% until 2017.
Equities should continue to make progress and government bond yields are likely to move modestly higher.
However, there will be volatility. Rising rates will expose weaknesses in the world economy so investors should be wary of riskier areas like emerging markets and low grade credits.
There is also the possibility that the pound continues to rise, particularly against the rest of Europe where interest rates are not likely to rise for sometime.
So it’s important to think carefully about exposure to the euro and to consider hedging (offsetting the risk of adverse price movements) it if possible.
This article first appeared on www.thisismoney.co.uk