The Fixed Interest Challenge

In March 2016 US Federal Reserve Chair Janet Yellen said she believed that the trajectory for interest rates will be lower for longer.

Speaking to the Economic Club of New York, Yellen was very clear about where she stands: the risks in the global economy justify continued low rates here in the U.S.

Whether you agree with it or not, this seems to be the policy direction of the Federal Reserve.

The firms view has long been that the Reserve Bank of Australia has been on the wrong side of interest rates since before 2007. For those who don’t remember the RBA raised interest rates during the Federal election, in the face of wreaking US circumstances. You may not realise this, but while we were experiencing interest rate hikes through 2009 and 2010, the rest of the world continued to see rates reduced toward ZERO, and even quantitative easing measures adopted.

As a tip, the RBA would have known the global game plan, as they go to Wyoming every year to attend the Federal Reserve Bank of Kansas, central bankers get together.

Obsessed by fighting inflation, which in the end never turned up the RBA was the only central bank in the world driving down the wrong side of the freeway!

The Australian dollar rose to USD 1.08, it crushed manufacturing, killed inbound tourism, super charged outbound tourism. Add to this that the bank guarantee murdered property developers.

The effect for fixed interest investors the easier answer at that time was to buy term deposits, but the world of markets is never constant and now that the RBA has figured out that a high dollar, (that is any number above USD 65 cents is suboptimal) is killing us.

The Australian dollar’s value used to be a function of the differential in interest rates between us and them. Well that was the theory after the float.

Today the dollar’s value is a function of the rate differential, their credit rating vs ours and a margin up or down for the demand in resources. The Australian Dollar is the 5th most traded currency in the world.

The only thing the RBA can do is drop the official rates and try and bring the dollar down.

So we expect interest rates to be lower for longer. This creates two issues:

  1. Significant proportions of client portfolios will have low income returns
  2. If interest rates rise rapidly capital is at risk

Back in 1994 when a Clinton was President of the United States and while Bryan Adams was bang out “Please Forgive Me” Australian interest rates moved from 6.55% to 7.02%. Bond managers who were long duration, they needed forgiveness. One manager had unrealised losses of $1.36 billion, which were created in just 45 minutes. Put that in context $1.36 billion is approximately the at completion value, of Chifley Tower in Sydney, Australia’s most expensive office tower.

So what are the risks of fixed interest investments how do we manage them and how in this low risk environment are we going to deliver returns that are commensurate with the risk.