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The current state of the financial markets presents opportunities to savvy investors. For starters, we are now entering a phase where monetary tightening is the order of the day and this has far-reaching implications for market stakeholders. The Bank of Canada (BOC), the Fed, and the Bank of England (BOE) have all shifted monetary policy from accommodative measures to quantitative tightening.
In 2017, the Bank of Canada moved swiftly to raise the bank rate twice, the Fed has acted multiple times since December 2015, and the Bank of England MPC voted 7-2 in favour of a 25-basis point rate hike on Thursday, 2 November 2017. Viewed in perspective, these movements are part of a broader trend of increasing interest rates on a global scale. This is especially important as it pertains to how credit markets function, and how stock markets will perform.
Experts Chime in on Interest Rate Hikes
Wilkins Finance trading expert, Montgomery Smyth Senior believes that there are far-reaching implications for even modest increases in interest rates,
‘…as we approach an era of quantitative tightening, it is increasingly important to line up your financial resources to better reflect current realities. Contrary to popular opinion, stock markets do not retreat in the face of higher interest rates – they rally. This is predicated on the assumption that higher interest rates are reflective of increased bullishness in the economy. Further, any possible adverse effects on listed companies vis-à-vis higher interest on loans is typically passed on to the consumer in the form of higher prices. Stock prices will rise regardless, given the modest 25-basis point rate hikes.
Now, if central banks were to rapidly raise interest rates, this would have a jarring effect on financial markets. The effects of a rate hike on currencies are far more noticeable. In the run-up to a central bank decision, currency traders will typically purchase the said currency, much like what happened with the GBP prior to the MPC’s decision. But caution is the order of the day: The minutes of the MPC meetings are equally important; indications that further rate tightening is unlikely will dampen demand on the sterling in this particular case.’
Mortgages and Lines of Credit
Current market conditions have far-reaching implications on credit facilities. For starters, variable interest rates are impacted by rising bank rates. Homeowners on fixed rates tend to prosper in an era of rising interest rates, while those on variable rates tend to bear the burden of higher costs. Adjustable-rate mortgages are typically eschewed in inflationary times. Recall that central banks are targeting an inflation rate of 2%. In the UK, the inflation rate (CPI) is around 3%, while in Canada and the US, inflation is persistently low. Interest rates are a powerful monetary policy tool that can be used to increase or decrease inflation rates accordingly. When markets tend to tighten, homeowners on variable mortgage rates may benefit from locking in a fixed interest rate.
Another issue that is causing consternation in the economy is overall household debt. The US and the UK economy are dealing with unprecedented levels of household debt. The biggest component of debt remains mortgage debt, followed by automobile loans, student loans, and credit card debt. As interest rates rise, the burden of interest-related payments increases. As a case in point, during each of the past 4 financial quarters, the typical Canadian household added $10 billion – $12 billion to the consumer credit balances.
When higher interest rates are slapped on outstanding debt, the overall burden is significant. This is felt in lower levels of personal disposable income. It should be remembered that credit card debt is typically fixed interest debt. Some credit cards have a variable interest rate component, and it is certainly worthwhile checking that aspect of your debt repayment schedule. Much the same is true with student loans which can be associated with fixed or variable interest rates.
The Final Word:
The consensus among analysts in an era of rising interest rates is to lock in favourable interest rates on mortgages and credit cards (if possible) and go long on currencies that show a tendency for additional incremental rate hikes. For example: the FTSE 100 index tends to reverse course when the GBP strengthens, but the FTSE 250 index benefits from increased interest rates.