The last few weeks have seen a big switch in the investment markets.
No not just a rebound in share market’s around the world but more interestingly a reversal of recent trends in the long-term bond market.
Over the last few weeks there has been a very large turnaround in the long-term bond market both in the US and in Australia. This has seen longer term government debt trading at significantly higher yields than a few weeks back.
In the US, the Federal Reserve has long indicated a bias towards increasing interest rates from the current emergency levels. The president – elect Trump has indicated he also would like to see higher interest rates or having rates back at more normal levels.
Throughout the year the long-term bond market has been bottoming out and the 30 year bull market in bond prices appears to be over.
In the long-term bond market yield and price move in opposite directions.
As interest rates rises the yield on bonds increases and consequently the price of those bonds decreases. The trend over the last 30 years has been for a bond price rally. This movement accelerated during the GFC as the Federal Reserve drastically cut interest rates to near enough to zero in a valiant effort to stimulate the US economy.
This rate cutting ended earlier this year and the Fed has indicated further rate increases are to come – maybe even this month. The long-term bond market has responded by reversing the long-term bond rally and we have seen bond prices fall away quite strongly as yields rise.
Locally the market has traded 10 year govt bonds 40 basis points higher at 2.75% just this month. This is a huge increase in a fairly stable market over a very short time frame and potentially signals the end of the RBA cutting cycle and the decade long bond rally
So why does this all matter to investors?
Well it all comes down to how interest rates are set.
The RBA has control over the official cash rate and this is the benchmark that variable rates are set against in the short term market i.e. less than 12 months. However fixed rates are set in reference to actual funding of the loans which are sourced in the long-term bond market i.e. longer than 12 months.
So in effect whilst variable interest rates are impacted more by RBA settings it is the long-term bond market that dictates where fixed rates are set the longer term bond market is really a reflection of where market participants anticipate the official rate will be in 1, 2, 3 or five years time
Currently there has been movement in fixed rates on the longer end of the scale (say at five years) but a lot of the major banks are currently still offering fairly attractive fixed rates at 2, 3 and 4 years in comparison to where variable rates are now.
What will happen in the next 6 to 12 months?
There are number scenarios that could play out and this will impact variable and potentially fixed rates as we go forward and consequently has an impact on investors who have long-term debt over investments
1) The RBA cuts rates further next year. However the banks do not have to pass this on and of more recent times have only been passing part of any rate cuts (say 10 basis points out of 25 basis point cut)
2) The RBA does not cut rates further. The trading banks independently of the RBA decide to increase rates due to concerns over funding costs and the like
3) The bond rally is over and rates continue to rise as prices of bonds fall in response to a rising official interest rate environment overseas and eventually here in Australia as well
These are all important issues for all investors with debt as something that you need to consider action on.
So should you fix your rate in?
This is a very individual question and is not something that should be broadly answered yes or no by all investors. You need to discuss this with your Hudson adviser and see what your longer term plans are for the debt in question.
Whilst fixing in rates now may allow you to get set at the lower point of the interest rate cycle there are downsides for fixing rates in as follows;
- If you get it wrong and there are further rate movement downward by the reserve bank and these are passed on by the trading banks that give you a lower variable rate than any fixed-rate you enter into now you will miss out. However the fixed rates on offer now are attractive to compare
- You cannot generally pay much more than 5 to $10,000 per annum into a fixed rate loan. If it’s an investment debt and you are not looking to pay that debt down in the fixed loan period than this is not an issue
- If you sell the underlying asset or you want to pay that loan back within the fixed rate period there is a penalty that will be incurred and this is something that you need to seriously consider before you fix in your interest rate
So the bottom line:
Is now a good time to fix in and should you as an individual investor fix you rate in?
These are questions only an individual can answer with the assistance of their adviser so if you are looking at this course of action please call your Hudson adviser.