Investing is a balancing act of weighing risks one against another. Most investors understand basic investment risk. They know, for example, if they invest in the latest startup, they could make a fortune by getting in on the ground floor, but they also risk their money if the company fails or turns out to be a scam. Other types of risk are political risk, currency risk, and inflation risk.
Inflation is when prices and wages rise weakening the value of money. Venezuelans are the latest victims of runaway inflation. Their money has so little value that people are weaving baskets out of the paper currency and trading the baskets for whatever they need. Consumer price index indicators (CPI) are a common way of measuring inflation, by calculating the purchasing power of a particular currency to a basket of regular consumer goods, or in Venezuela the basket itself.
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Why Should I Care?
Inflation is returning to US economy and this is a top concern for investors globally. Some inflation is healthy. Deflation, like what Japan experienced, is stagnating. They went through a prolonged period of extremely low-interest rates without growth. Normally low rates are stimulating, but companies in Japan were so heavily burdened they refused to take on more debt.
Rampant inflation is unhealthy and creates a great deal of instability in an economy and it falls on central banks to temper it. They use monetary policy to try to control interest rates and the pace of economic growth. One of the tools at their disposal is raising or lowering interest rates. The U.S. Federal Reserve had 3 raises in 2017 and another 3 are expected for 2018.
Changes in interest rate levels can be positive or negative, depending on your perspective. Retirees are generally happy whereas people buying their first home are not. Interest rate levels determine the cost of borrowing money.
When central banks inject liquidity into financial systems, it means more money is available at a lower price, and companies can expand and individuals can buy homes. When central banks tighten liquidity, there is less money available and the price rises. The price of borrowing money is the interest rate.
What Is Interest Rate Risk?
People are vulnerable to interest rate risk in an inflationary environment. The anticipation of rising interest rates creates instability and volatility in markets. In our current economic environment, economic indicators are strong and stock markets had solid gains in the past year.
There is a danger of things overheating and so central banks will do what they can to slow down the pace of growth and prevent things overheating and crashing, which they do by removing liquidity from the banking system, which raises rates and slows economic growth. Other times they will try to stimulate growth by making more money available and lowering borrowing costs.
How Rate Increases Affect Stock Markets
As a general rule of thumb, lower interest rates are associated with rising stock markets, and interest hikes with market drops. Lower interest rates correlate with economic growth because they encourage business to borrow money and invest in their company’s growth. Lower costs of existing debt reduce expenses and improve earnings. They also reduce the costs of borrowing on margin so there is more buying which provides additional support to stock markets.
Looming threats of interest rate increases move markets as much as the raises themselves. Financial professionals from London to New York to Tokyo analyze every word, every change in tone of voice, every nuance when central bankers speak. In order to tamp down volatility, in the last few years, regulators have been more transparent and signal their intentions well ahead of taking action.
Practical Tools For Individual Investors To Mitigate Interest Rate Risk
- Shorten average bond duration. Long-term bonds and coupons lose the most value when interest rates rise.
- A good general strategy for private investors is to use laddered bonds for the debt portion of their portfolio. Divide the debt portion and invest it in equal amounts in short, medium and longer term bonds or coupons. As bonds mature, that portion is reinvested at the longest duration. Most of the time, the longer bonds have higher rates, so with this strategy, one is always getting the highest rate possible without having to predict the future of interest rates.
- Pay down debt where possible because it’s about to get more expensive. Use unexpected windfalls life tax refunds, bonuses, and inheritances to pay off credit cards and when possible makes an extra mortgage payment. Active traders should review their margin positions and consider reducing their market exposure.
- Covered Call Writing is a strategy to generate income in volatile markets. It is the only acceptable derivative strategy for non-professional portfolios. The risk involved is that the investor may be forced to sell an underlying stock if the market goes up and the option is called. They lock in a gain but may have to pay capital gains tax and the costs of reinvesting the cash.
- Precious metals are a traditional hedge against inflation and rising interest rates. They tend to correlate with interest rates and inflation. Investors can buy gold, silver or platinum directly, precious metal funds, or mining companies. Junior mining companies are notorious for scams so stick to established, larger capitalized companies.
- Bonds and high yielding stocks are the most sensitive to interest rate increases. With 3-4 interest rate increases expected from the Fed this year, it is sensible to alter a portfolio’s weight towards growth stocks, and sectors less sensitive to interest rate increases, including the aforementioned precious metals sector.
About Wellington Capital Group
Wellington Capital Group is a wealth management firm based in central Tokyo. To find out more about protecting your capital from interest rate risk or to review your current holdings, please contact the office in Japan and ask to speak to an Investment Advisor.
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