As a regular fixture in financial news, central bank decisions on interest rates can leave many investors wondering what these calls mean for their portfolios.
Often investors might not know how to react to these announcements. After all, a 0.25 per cent increase in the official cash rate might not seem as significant as a 2 per cent swing on the local sharemarket, representing billions of dollars in gains or losses.
But these types of announcements are a strong signal to bond and equity markets, and well worth investors understanding and taking notice of, more in the sense of forming expectations for their portfolio, rather than acting on them.
Official interest rates are typically rates banks will pay on loans they take on a short-term basis. While central bank policy by no means has a vice-like control over markets, it does have some strong influence that can directly affect investor portfolios.
For instance, the US Federal Reserve recently announced a 0.25 per cent increase in its short-term rate, bringing it to 1.25 per cent. This is firstly important because it sets a baseline of the rate at which financial institutions will make short-term loans to one another. It also directly influences the yield paid by government bonds, which can in turn influence rates on debt issued by companies.
It is important to note that the market expects these rate rises, and in many cases, the role of the central bank is to not only manage the economy but also to avoid surprising the markets. This means most rate rises, including the recent US Fed move, were already priced in by the market.
As well as maintaining a strong influence over debt markets, official interest rates also send strong signals to sharemarket investors. For instance, the US Fed rate rise was based on positive data indicating that the US is creating jobs and growing its economy. This sends a signal to investors that US companies are confident in the future and that they have a good foundation for success.
Investors should also remember that rates moves are one of many things that impact the prices of shares and bonds. Combining the fact that the market already prices in these moves and that other factors will impact security pricing makes any action based off of rate expectations extremely challenging.
So then, what exactly do these rate calls mean for investors?
When it comes to bonds, a rate rise can mean short-term pain but long-term gain. Because a rate rise signals that yields on newly issued bonds will be higher, older bonds with lower yields are suddenly worth less on the secondary market. This means bond portfolios might take a short-term hit after a rate rise, but investors who keep reinvesting are likely to benefit from higher-yielding bonds over the long-term as they benefit from greater income paid by newer issues. This is where a diversified bond fund can be of use, as they can continually invest in newly issued bonds.
When it comes to shares, investors can consider a rate rise a vote of confidence by a central bank in its nation’s economy, which can be a good sign for locally-listed businesses. Expect rate rises and cuts to influence sharemarket values.
So, what exactly should investors do when it comes to rate decisions? The answer is to be aware of what they mean in the short-term, but remain focused on long-term.
The reality is that the things you can control, like diversification, cost and risk in your portfolio, are bigger drivers of long-term returns than things you can’t control, like political events, market movements, and central bank rate decisions.
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