Investors should not expect a major bear market for asset prices following a future rise in interest rates but a shorter term buying opportunity for bonds and equities, according to a study by Deutsche Bank, which says historical data suggests the worst tends to be felt toward the end of a rate hiking cycle.
For several years attention has increased on an almost monthly basis on the spectre of interest rates in the US and UK rising from their historical lows of 0.25 and 0.5 per cent respectively, where they have rested since the 2009 nadir of the market’s plunge during the financial crisis.
Examining data going to back over 100 years, Deutsche Bank strategists Jim Reid, Nick Burns and Seb Barker found that during rate hike cycles in the US and UK, both bonds and equities tended to remain supported. The analysis covers 35 Bank of England hiking cycles since 1914.
Impact of first UK rate hike in the cycle on UK assets since 1914
Source: Deutsche Bank
While the team does not have a long enough history for all credit spreads to include in all the analysis, it did include the performance of real and nominal GDP, inflation, equities, and bonds for each cycle period from the first hike to the last hike in the cycle, as well as what happens in easing cycles in the three years before each event.
“In terms of market reaction to the first hike, UK equities clearly see weaker performance a year after than a year before. There is an improvement as the year progresses though as after three months equities have typically been lower and although a positive number returns after six months, the 12 month performance is comfortably more than double the 6 month one,” the team said.
“For all hikes UK equities have a slight bias to lower returns a year after the ‘average’ hike than a year before but it’s not sizeable. As would be expected, equities react more favourably to the ‘average’ easing cycle than to the average tightening cycle even if the difference isn’t large.”
“For the average of all hikes, UK bonds actually see their worst performance in the six months before the hike whereas they’re stable in the quarters after. This is again likely due to the immediate negative reaction of bonds to the first hike in the cycle which shows up in these averages i.e. hikes have already influenced the ‘before’ period.”
While it is impossible to say for sure when interest rates will rise and the majority of commentators currently predict early 2016 as the most likely period, it is fair to say the first eight months of the year have been rather dire for UK bonds not dissimilar to other shorter term periods before a hike.
According to FE Analytics, the average performance of the IA Sterling Corporate Bond, Sterling Strategic Bond, IA Sterling High Yield sectors has been meagre in 2015 with an overall loss of 0.08 per cent in the case of the former and a slight positive return of 0.62 per cent and 1.47 per cent for the other two, respectively.
As the graph below shows, this includes a fairly robust performance in the first three months of the year following by mostly ongoing weakness since then.
Performance of sectors in 2015
Source: FE Analytics
Despite the sanguine findings for investors from the study the team says there is one major difference to other periods of history in the six/seven year recovery form the financial crisis.
“Since 1950, all hiking cycles to date have been in a super cycle of increasing leverage with growth eclipsing pre-recession peaks very quickly post the recovery commencing,” the team said.
“By contrast this has been a uniquely slow recovery from what was the worst recession in the sample period. This has also been by far the longest period without a rate hike after the previous recession ended.”
“In the 12 cycles since 1950, the median length of time until the first hike once the last recovery starts is 30 months. This current cycle is 74 months and counting and without a rate move, eclipsing the previous high of 35 months without a rate hike.”
They also add there is a bias to slightly higher inflation after a first hike, although it must be remembered current inflation is at a very low rate historically of just 0.1 per cent.
“This probably shows the momentum that was there before the tightening which the first hike can’t on its own immediately reverse. There are no clear trends in nominal GDP as slightly lower real growth is cancelled out by slightly higher inflation.”