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It is no longer a question of if, but when.
This autumn will mark the beginning of the end of the low interest rate era. Soon – potentially as early as next month – the US Federal Reserve is expected to raise its benchmark lending rate for the first time since 2006.
The exact timing is under debate, following China’s surprise currency devaluation this week, but investors should not rest on their laurels.
The Bank of England was surprisingly dovish last week about the timing of a UK rate rise – now anticipated early in 2016 – but this provides an opportunity to assess your investment portfolio and personal finance strategy in anticipation of the inevitable.
The first rate rise will command huge attention, but it's the timing and scale of the subsequent rises that require forethought. Down the line, bigger questions include the allocation of assets in your portfolio over coming years as bonds and so-called “bond proxies” lose their lustre, and cyclical stocks are tipped to return to favour.
But this must be weighed against the disruptive effect that higher debt repayments are likely to have on the consumer economy and potentially, the property market.
At a personal level, this could translate into a decision to fix your mortgage now, grab a zero per cent credit card deal, or take advantage of a cheap car loan – or even check out tracker rate savings bonds.
As for the timing of a UK rise, February is the most popular prediction. But this is only an assumption – the timing of any US increase could make it easier for the Bank of England to act earlier.
“Either way, it’ll be the first upward move in interest rates since July 2007,” says Andrew Hagger of Moneycomms.co.uk. “The increases are likely to be in small steps of 0.25 per cent every few months but whether you are a borrower or a saver it will increasingly have an impact on your finances.”
Here, we give some pointers on how to prepare so you can reposition in advance of the rise when it comes.
For equity investors, the most important question is not when the first rate rise will occur, but what the pace of future rate rises could be.
In the US and UK, the theory is that rates are rising from historic lows because these economies are now in a healthy state. But in practice, people aren’t buying into this argument.
Many individuals are holding what have been dubbed “bond proxies”, says Thomas Becket, chief investment officer at PSigma Investment Management. This is City shorthand for global blue-chip companies that pay a dividend and have traditionally been judged as safe, Unilever and Diageo being two examples.
“In equities, we would suggest that the defensive ‘bond proxy’ [consumer staples with predictable returns] company shares that have benefited in the last five years from low interest rates could well be vulnerable when interest rates and market bond yields start to rise,” he says.
“The valuations of many such companies to us look extremely expensive and their income premium could well be eroded quite quickly, potentially putting downward pressure on share prices.”
The pace of future rate rises could prompt a cyclical swing. If sentiment changes rapidly, and rates rise more quickly than expected, the risk is that bond proxies, safety plays and income stocks will get crushed as cyclicals take off.
Mr Becket recommends repositioning portfolios into sectors including car manufacturers, airlines, furniture retailers, clothing stores, hotels and restaurants that would benefit from a more benign economic environment.
The banking and insurance sectors will benefit more immediately from a rate rise, as they raise rates for borrowers but hold off passing on the increase to depositors, though some equity managers think this is already priced in.
The supermarkets – traditionally viewed as a defensive sector – could have more woes in store when rates rise. The weekly food shop is the first thing consumers say they are likely to cut if their disposable income is eaten into by higher debt repayments, according to a BlackRock survey.
Interest rate rises spell trouble for bondholders in particular. In times of economic trouble, the debt issued by governments, companies and banks has been lapped up by investors thanks to fixed returns and the fact that bonds have been seen as a safer bet than equities.
Conversely, when optimism prevails and prices are expected to rise, the idea of a set return becomes far less appealing. New bonds are issued with higher rates and older bonds tend to see their prices fall.
Bond yields – the calculation of how attractive the interest rate is compared to its price – are close to record lows, suggesting that the market takes a dim view of optimistic economic forecasts.
Yields on two-year debt issued by Germany, considered one of the world’s safest investments, hit a record low of minus 0.29 per cent on Wednesday, while bonds with the same maturity in the UK have a yield of just 0.51 per cent. When interest rates start to rise, expect these figures to climb.
Shorter term debt tends to be the most sensitive to rate rise expectations, while longer dated bonds are more vulnerable to the effects of inflation, which erodes the value of their payments. How far and how fast yields move will depend on whether an interest rate rise comes as a surprise.
Retirement savers who rely on the interest from their savings to supplement their pension income will no doubt greet an interest rate rise with loud cheers.
“Other good news for this sector of society is that annuity rates which have been at historical lows could improve with a rise in interest rates, which means those planning to retire soon could secure a higher income,” says Maike Currie, associate investment director at Fidelity Worldwide Investment.
Less positive is the danger that pensioners could see a fall in the value of their pension funds. This is because when investors near retirement age, money is often automatically moved out of the stock market and into bonds as a way of de-risking pension savings. “However, bond prices tend to fall when interest rates rise in order to increase the yields and attract buyers,” she adds.
Tangible assets such as gold tend to do well when rates are low and inflation is rising. Unfortunately, investments that hedge against inflation tend to perform poorly when interest rates begin to increase, simply because rising rates curb inflation.
Despite this week’s fillip, the gold price has fallen over 5 per cent this year, hitting a five-year low in July as the market focuses on an expected rate rise by the Fed. Gold doesn’t provide any yield, so with higher interest rates, other assets become more attractive.
The key test will be the speed of the Fed rate hike cycle – any faster-than-expected rise in rates is likely to be even more negative for gold. But it’s unknown how investors in gold-backed ETFs will react. The last time the Fed started a rate hiking cycle was in 2004, when ETFs tracking gold were only just being set up.
Conversely, if the Fed rate rise leads to a broad sell-off in financial assets and slower global growth, that could benefit gold, which is often bought as a safe haven asset in times when markets are dramatically falling.
Mortgages and property
Many homeowners will be hit hard by a rate rise, and the bad news is that the cost of loans has already gone up in anticipation of an increase. Mortgage swap rates – the cost of borrowing for banks – have been steadily rising over the past few weeks, putting pressure on lenders to raise the cost of fixed-rate mortgage deals.
Borrowers who are on trackers or variable rate loans should consider switching to a fixed-rate deal. According to the Council of Mortgage Lenders, this group of borrowers represents over half of all existing mortgages.
As an example, if rates were to increase by 1 per cent, this would add an extra £128 per month to the typical repayment on a £250,000 home loan over 20 years. Similarly, a borrower with £350,000 outstanding would have to find an additional £179 per month from the household budget.
However, beware the impact of arrangement fees, as many of the products with the lowest rates have very large fees of £1,500 and over. Those with larger loans can claw back the fees with high monthly savings when rates rise, but for those with smaller mortgages, a slightly higher fixed rate product with a lower arrangement fee may work out cheaper.
“Banks and building societies were offering mortgage interest rates at some of their lowest levels in June and July, but we have already seen a number of providers withdraw their best offers in anticipation of Bank of England interest rates increasing,” says Simon McCulloch, director at Comparethemarket.com.
A further conundrum is what effect rising rates will have on property prices.
Meanwhile, lenders are already starting to raise rates, albeit subtly. The average five-year fix has risen from 3.24 per cent a year ago to 3.28 per cent today according to Moneyfacts. But the rate of change is speeding up. In the past few weeks, the average two-year fixed rate has risen from 1.75 per cent on July 14 to 1.86 per cent today.
Rates increased on 36 mortgage products last month, up from only six in January, while the number of products for borrowers with 40 per cent deposits dropped for the first time in six months, according to Moneyfacts. Barclays and Santander are among a number of banks that increased mortgage rates last week.
One of the best options for someone looking for a two-year fixed rate comes from Platform, offering 1.59 per cent. A three-year fixed rate is available from the Post Office at 2.60 per cent and a five-year fix is just 2.60 per cent from Leeds Building Society.
“This just goes to show that we do not necessarily need a base rate rise for mortgage rates to go up,” says Charlotte Nelson at Moneyfacts. “Borrowers should not rest on their laurels and will need to act fast, as these deals will not be around forever.”
Those wanting to purchase big ticket items using debt should act fast to get the cheapest deals as rates are at record lows on credit cards and personal loans.
If you have an outstanding credit card balance, now is the time to transfer a long-dated zero rate deal. The cheapest credit card deals currently available are from Halifax with its Balance Transfer Card at zero per cent for 36 months with a 2.45 per cent fee; and Santander’s 123 Credit Card with 23 months at zero per cent interest and no fee for transfers.
“We’re unlikely to see credit card and personal loan rates increase immediately on the back of a 0.25 per cent base rate rise – particularly with the current fierce rate war in the personal loans market – but once we’ve seen two or three rises of this size then unsecured borrowing rates will start to increase too,” says Andrew Hagger of Moneycomms.
The exception is Halifax credit card customers who under its terms and conditions have had their interest rate movements linked to the base rate.
New car sales in the UK rose for the 41st month in a row in July, boosted by innovative and attractive financing deals and personal contract plans, but there are growing concerns about the impact that interest rate rises will have on demand in the medium-term.
According to Moneyfacts, the average rate on a three-year £5,000 car loan has fallen from 8.6 per cent to 8.4 per cent over the past month – and could potentially fall further before next year’s anticipated rate rise. As rates on such borrowing tend to be fixed for the duration of the loan, if you’re keen to buy a new motor, now is the time to book a test drive.
Following years of pitifully low rates – often below the rate of inflation – savers can look forward to some respite as bank rates move up. However experts warn that rates are unlikely to move up as much as they should as they have become unlinked from the base rate.
If you are a saver then a 1 per cent hike could give you an extra £120 per annum – after 20 per cent tax – on a £15,000 savings pot. However don’t expect banks and building societies to be so generous. This will be the first time for many years that they will be able to adjust their profit margins and may choose to pass only some – or in some cases none – of the rate increase to customers.
“Experience has shown that providers rarely increase rates by the full base rate rise across the board,” says Sue Hannums, director at rate-monitoring site Savings Champion. There was a time when savings rates rarely fell outside a base rate change. “Fast forward to today and more than 3,500 existing savings rates have been cut in the past three years since the introduction of the Funding for Lending Scheme [despite] no movement in the base rate for over six years,” she says.
For savers who do not want constantly to switch accounts to get the best rates, there are a number of tracker bonds on the market that will pay a certain percentage over the base rate.
Halifax offers an 18-month bond paying a fixed 1.43 percentage points over the base rate, currently at 0.5 per cent. So if the base rate shifts up to 0.75 per cent, its rate will automatically rise to 2.18 per cent. Kent Reliance pays 1 percentage point over base rate for two years.
Some notice accounts work in a similar way to tracker bonds, and the best of these is from Secure Trust Bank, paying 2.05 per cent on its 183 day notice account.
But do not be tempted by a fixed-rate savings bond, warns Tracy Dickerson at Money.co.uk. “Banks are dropping rates in preparation for having to pay more so keeping a close eye on returns is a must,” she says. “Resisting the temptation of long term fixed bonds that don’t let you get at your money may also be a wise move.”
Additional reporting by Elaine Moore and Henry Sanderson