Since interest rates dropped to record lows in both the US and UK, investors have been anticipating their rebound and picking their investments accordingly.

For months on end, investors have been wondering when interest rate rises will come and what the best investment strategy for such rises is. Since interest rates dropped to historical lows of 0.5% in the UK in March 2009 and to 0.25% in December 2008 in the US, economists and markets alike have been aware that rates would have to rise once the economies rebounded.

The eurozone already raised interest rates from the 2009 to 2011 level of 1%, but then lowered them again. And, the European Central Bank (ECB) has just introduced yet another drop from what was an already record low of 0.25% to 0.15%. Meanwhile, the general view is that the monetary committees of the Bank of England and the US Federal Reserve are looking to raise rates in the near term.

“While some central banks are starting to consider rate hikes – the Bank of England is probably in the vanguard of that – others such as the ECB or the Bank of Japan are moving in the opposite, easing direction,” says Huw Pill, chief European economist and co-head of the economics team at Goldman Sachs and a former deputy director-general of research and head of the monetary policy stance division at the ECB. “This is a big difference from historical behaviour, where broadly speaking rates have moved together. Over the past 30 years, after a fashion, rate cycles were reasonably closely correlated.”

Especially after the ECB’s latest decision to lower rates, it seems clear that these dynamics have changed, as the consensus view is still for rate increases in the UK and US in the near term. Andrew Sentance, senior economic advisor at professional services firm PricewaterhouseCoopers and a former external member of the Monetary Policy Committee (MPC) of the Bank of England, expects his previous employer to act as early as August, likely around the time of the inflation report.

“A first move in early 2015 seems quite unlikely because that would mean having a first rise in interest rates so close to the [UK] general elections [which are expected in May 2015],” he says. “There is a strong argument for the MPC to make the first rate rise before the end of this year so that people get used to the idea. A second rate rise, even if it was close to the election, would then just be a continuation of the same policy.”

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The equity edge

If Mr Sentance is right and the Bank of England does raise its rates this year, many investors are likely to see this as detrimental to bond markets and shift their interest to equities. Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management, echoes this: “We would favour equities over fixed income because our economic outlook is that we are mid-cycle, which means we see the first inflation pressures and the first pressures of rates going up, but the growth in the economy is still strong and stable enough for equities to do well.”

Mr van den Heiligenberg would choose European equities over those from the UK and US, because he sees a higher potential for profit growth in Europe – about 15% – compared with, for instance, high single digits in the US.

Meanwhile, some investors are becoming more specific in their choices in an attempt to maximise value.

“There is more noise around merger and acquisition [M&A] activity and more people are looking at individual stocks that could benefit from a specific story such as M&A,” says Hubert Le Liepvre, global head of financial engineering in the cross-asset solutions team at Société Générale. “To take advantage of these opportunities, we have partnered with an external asset manager called Lutetia Capital, which has a merger arbitrage fund. It is screening the market for opportunities, and we have an index that is providing leverage on its fund.”

The index, SGI Merger Arbitrage Index, returned 10.86% in 2013, on the back of a revival of M&A. In 2014, it had returned 0.93% by June 2.

Steep moves

Another step for investors with a view that long-term interest rates will rise is to turn to structured products, such as steepeners. Société Générale’s cross-asset solutions team is creating such instruments, which benefit from rate moves.

“A steepener is a note issued by Société Générale, which is paying a structured coupon that is providing exposure to the difference between, for example, 10-year rates and two-year rates,” says Mr Le Liepvre. “In the past two years we have been pitching steepeners because investors believed that the long-term interest rates would increase at some point. As a matter of fact, it hasn’t happened as of yet, but we are proposing this product because some investors believe rate increases will happen at some point in time.”

Insurance companies and pension funds are the prime target for steepeners because of their need for long-term investment, so it can help them match their liabilities, he adds.

Steepener products can come in different forms, including with different leverage or parts of the curve. An example would be a 20-year steepener with a fixed 11% coupon for the first year. Thereafter, the notes pay four times the difference of a 30-year constant maturity swap [CMS] and the two-year CMS subtracted by 0.25%, as in Société Générale’s series 2013-82 callable notes due September 2033.

“The day the US starts to increase the long part of the rate curve, then we will see a clear increase in interest in these kinds of products,” says Mr Le Liepvre.

Bonds stay strong

Despite all the negativity around bonds, there is still a case to be made for the fixed-income asset class, even if the view is that rates will rise. Michael Howell, managing director at CrossBorder Capital, an investment advisory firm tracking capital flows across 80 countries, says that while central banks will start tightening policy, the liquidity in the market is drying up, which suggests that overall the economy is likely to worsen.

“As a result of those greater risks you would favour an allocation out of equities towards fixed income,” he says. “You’ve got the paradox this year of prospectively rising interest rates but you actually have bond markets, which are rallying quite strongly.”

Year to date in 2014, those who picked bonds over equities have seen bigger gains, and Legal & General’s Mr van den Heiligenberg says that so far the general view of favouring equities has worked against many investors because long-term interest rates have gone lower.

“Had you decided to lower your interest rate sensitivity a lot at an early stage this year, you would have lost out on quite a lot of performance because credit, and especially emerging market credit, has outperformed quite a lot versus equities,” he says. “Equities are rallying at the moment but it has proven a bit dangerous to focus on rising interest rates too early.”

Emerging market debt had returned 8.6% in 2014 by the end of May, the largest amount of all fixed-income asset classes. This compares to 7.9% stock market returns through the MSCI Europe Index, excluding the UK, so far the highest performer in equities in 2014, according to JPMorgan asset management data.

Waiting game

Legal & General’s macro-economic house view is in line with broader expectations for rate rises starting in the second half of this year, while some are not seeing rises before 2015. Goldman Sachs predicts that there will be no rate increases before the third quarter of 2015 in the UK and likely not before early 2016 in the US. This forecast is based on the view that both the Bank of England and the Fed are gambling that their respective approaches work.

“We believe that the Bank of England is prepared to keep rates on hold for longer than the market currently expects, on the basis that productivity growth [which has been abnormally low over the past four or five years] will revive and that new and untested macro-prudential instruments [aimed at making it harder for more vulnerable households to leverage up on mortgage borrowing] work effectively,” says Mr Pill.

In the UK, concerns over rising prices in the housing market and the cheap availability of mortgages are leading to calls for interest rates to be increased.

“The longer interest rates are at such a low level, the more people are taking on debt with maybe unrealistic views of what it will ultimately be costing them in the longer term,” says Mr Sentance. “We are actually encouraging a build up of debt based on interest rates levels that are not sustainable for the future. The fact that inflation is low gives the Bank of England and the Fed the scope to move rates up gradually, which they may not have if inflation was a real and present danger, when rates would have to be increased much more sharply.”

As for the US, Goldman’s expectations are for the Fed to keep rates on hold, since it expects participation rates in the labour market to increase as the economy recovers. Mr Pill explains that while unemployment in the US has fallen significantly from close to 10% in 2010 to 6.3% in June 2014, people are also more inclined to leave the formal labour market and pursue other paths in the US than in countries where there are more generous benefits systems.

“Even though the unemployment rate is now low, as the economy picks up, we expect the unemployment rate to stabilise at this level as more people re-enter the labour market as vacancies appear,” he says. “Owing to the potential for rising participation rates, the slack in the economy is much greater than the unemployment rate suggests.”

Either way, long-term interest rates will likely not rise to historical levels but might stay at 3% or lower, Mr Pill adds, partly driven by lower inflation expectations and general inflation targets of about 2%.

Extraordinary measures

”Because the main focus is on the UK, the US and the euro area, people talk as if there haven’t been any interest rate rises since the crisis, but there have,” says Mr Sentance. “There was a period in 2010 and 2011, when a number of economies – including Canada, Sweden and Australia – started to raise interest rates. In fact the ECB did as well, but it then lowered them again because of the euro crisis.”

Meanwhile, the ECB’s decision to lower the rate on the deposit facility to negative 0.1% effectively imposes a tax on banks for holding deposits with the ECB. The measures are meant to boost lending to the real economy, while a weakening of the strong euro is also aimed at supporting economic growth in the eurozone.

“This process of supporting the economy and deleveraging still has a long way to go in Europe,” says Mr Pill, “but the consequences of negative rates over longer horizons remain a bit uncertain. I don’t think the ECB will want to acquiesce in negative rates for any longer than exceptional circumstances dictate.”

The president of the ECB, Mario Draghi, explained the decision during the press conference following the meeting of the MPC. “The package has… three parts. The first is to ease the monetary policy stance. The second is to enhance the transmission to the real economy. And the third is the reaffirmation that we'll also use unconventional instruments if needed, if further easing is needed,” he said.

Alongside these steps, the ECB has also introduced a targeted longer term refinancing operation, which provides banks with the option to borrow money with a September 2018 maturity, to lend to households and non-financial corporations at cheap levels.

The ECB’s intervention has already seen the German stock index DAX break through 10,000 points for the first time in its 26-year history on June 5, and it is likely to keep investors sweet looking at the eurozone.

The smart hedge

“If you want to have some interest rate sensitivity in a global portfolio, we prefer to have interest rate sensitivity in the eurozone, because the ECB is probably the furthest away from increasing rates,” says Mr van den Heiligenberg. “And, we think particularly Australian rates are attractive if you need to take interest rate sensitivity somewhere in the global portfolio.”

Australia’s official cash rate is 2.5%, comparably high, but actually at a record low for the country, and its 10-year bonds are about 3.75%. Therefore, even if for some reason interest rates do not rise, L&G still sees the return on those bonds as quite attractive.

Even so, Australia can also be instrumental in another way. L&G is gearing up for a potential systemic shock, which it expects could come out of China, should the strong economic growth of 7.5% suddenly fall.

“We have seen some defaults of companies in China and given its credit-intensive economy you might expect that China is the area where we could see a potential shock coming from,” says Mr van den Heiligenberg, “Australia is an economy that is particularly sensitive to the Chinese economy and therefore if Chinese growth is lower than expected, you would expect Australian rates to fall quite a bit. That’s where we seek smart hedges.”

This would make exposure to Australian bonds attractive, because with a drop in rates, the inverse correlation of yield and bond prices would see the value of the products rise.

Mr Howell points out that from a point of view of liquidity, he thinks of markets in four phases: rebound, calm, speculative and turbulent. “Two-thousand and twelve was a rebound year, 2013 was a calm year, where equities excelled, 2014 is what we call a speculative investment year, where you can see positive gains but you will get a lot more choppy performance, and next year, we think is a turbulent year,” he says.

Should Mr Howell’s or L&G’s systemic shock scenario be correct, investors might have more to worry about than just which investment choices are best when interest rates rise; they might have to work out the effects of more serious challenges to their portfolios.

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