The “American Rescue Plan” was passed by both houses over the weekend paving the way for US$1.9 trillion worth of stimulus into the US economy. While this should be viewed as a major positive, fears emerged that the size of the fiscal stimulus would force the US Federal Reserve to scale back monetary policy stimulus and raise interest rates earlier than it anticipated. This same scenario occurred in 2013 and is commonly referred to the so-called “taper tantrum”.

Generally speaking, a gradual increase in interest rates over time should be viewed as a positive as it reflects to an improvement in economic conditions. Nonetheless the market wasn’t all that satisfied that US Federal Reserve Chairman Jerome Powell didn’t use stronger language to abate the markets concerns around inflation and interest rates and as a result the share market volatility has increased significantly.  

Why is this important? Higher interest rates mean higher cost of capital for companies and in turn lower profits. If interest rates rise, then many fixed interest investments (Defensive) actually experience a negative return. This is referred to as interest rate sensitivity or duration. Basically, if a new fixed income security is issued at a higher interest rate than the old one, then the one currently in the market, with a lower interest rate, declines in value leading to a negative return.   

With this in mind we have favoured “floating” rate fixed income securities, over “fixed” securities, in light of the historically low interest rate environment. Floating rate securities generally reset every 90 days, up or down, depending on the interest rate direction. We are currently holding very low duration of circa 0.20 years. Another thing to note is that the benchmark duration has been increasing as Governments around the world have issued more bonds (debt).  

While Australia's economy still shrank by 1.1% overall in 2020, after suffering its first recession in nearly 30 years and steepest quarterly Gross Domestic Product (GDP) fall in history, the rebound in the second half of the year also set records. GDP grew 3.4% in the September quarter and figures out last week indicated a further 3.1% expansion in the December quarter. The strength of the resurgence in activity took economists by surprise, and it was the first time in the more than 60-year history of the National Accounts that GDP has grown by more than 3% in two consecutive quarters.

While the share market won’t like higher interest rates it is not unusual for shares to pull back when yields rise. We believe we will continue to experience volatility in the short term as markets adjust to policy changes however the fiscal and monetary stimulus will ultimately drive markets higher over the medium term. As a result, we have been closing our underweight position to growth assets over the past 2 – 3 weeks. 

 Please do not hesitate to contact us if you have any questions.

Kind regards,

The Coastline Private Wealth Team.