By Tom Bradley
I recently attended a pension seminar. As part of the program, the organizers used a cool interactive polling system to gauge where the audience stood on certain issues. While there was plenty of good information provided throughout the morning, what stood out the most for me were the results from one of the questions: “When will interest rates rise in earnest?”
Of the 100 plus trustees and consultants in attendance, only 3% thought rates would ‘rise in earnest’ in 2013. By far the most respondents (63%) said rates would rise in 2015 or beyond, while 20% said they would not go up significantly.
I understand the reasons why people expect rates to stay low (weak economies, stimulative monetary policy and overextended governments). Indeed, the manager of our Income Fund, Connor, Clark & Lunn Investment Management, doesn’t expect rates to rise significantly over the next year.
But that doesn’t change the fact that the consensus around interest rates is truly remarkable (Read: extreme). Think about it. We’re coming off a period when rates have steadily declined while inflation has been remarkably stable (call it 1.5-2.5%). We’re now at a point where short to medium-term government bonds trade at negative yields (the yield is not enough to offset inflation). So with bond valuations as stretched as they’ve been in 30 years, investors have never been more confident that rates will remain low.
To my way of thinking, only 3% in the rising rate camp screams complacency. Near-zero rates may be here for years to come, but the chance of them being significantly higher sometime in the next few years is not 3%. It’s considerably higher than that.
3% also tells us that we need to understand where we’re sensitive to interest rates and how our assets (real estate, bonds and high-yielding stocks), liabilities (mortgages, credit lines) and cash flow will be impacted by higher rates. As a good control measure, we should all assume higher rates when calculating the affordability of a house or future returns on our portfolios.
We shouldn’t be complacent about the current state of credit markets. It’s not sustainable. Bond investors will eventually demand yields in excess of inflation. Maybe it won’t happen until 2015 or beyond, but we should prepare in earnest today.