Where is the Best Place for Your Cash when Interest Rates are Rising?
by Jim Fuell, Head of Global Liquidity, EMEA, J.P. Morgan Asset Management
With markets braced for the normalisation of G7 interest rates, the outlook for global monetary policy is a major concern for all cash investors. The wrong investment strategy in a rising interest rate environment could lead to a loss of yield and potentially expose investors to higher credit risk. That’s why at J.P. Morgan Asset Management we are focusing our latest Liquidity Insights paper on the relationship between cash management and the interest rate cycle.
Our Liquidity Insights programme is designed to share the firm’s intellectual capital through white papers, economic and market bulletins, surveys, conference calls, web discussions, investment forums and other face-to-face meeting opportunities. Our aim is that the Liquidity Insights programme is relevant and practical and designed to deal with matters of current interest to cash investors. Recent titles include:
- Instituting an investment policy
- A practical guide to evaluating counterparty and sovereign risk
- Weighing the risks and rewards for cash investments
Cash management and rising interest rates
Interest rates in many OECD countries are at, or are close to, record lows. However, with inflationary pressures beginning to build, most investors expect the major central banks to begin raising interest rates soon. The European Central Bank has already started to tighten policy, following a 25 basis point increase in April. The Bank of England is expected to follow later in the year as it tackles an inflation rate that is more than double its target. Even the US Federal Reserve has signalled that rates are likely to rise in 2012, if not earlier.
With interest rates likely to rise quite steeply and for a prolonged period from their current ultra low levels, it makes sense for treasurers to plan ahead and adapt their cash investment strategies so that they are not adversely affected during the rising cycle. Choosing the right strategy is particularly important as rising interest rates will impact the return from cash and short-term investment vehicles in different ways:
* Overnight bank deposits should generally track rises in interest rates quite closely, although investors should be aware that, due to their exposure to only one counterparty, credit risks may be higher. Counterparty risks can be reduced by diversification, while potential returns may also be higher from a more diversified investment.
* Term deposits will lag shorter-dated deposits as they need to wait out the term of the deposit before resetting to a higher interest rate. They also carry the same counterparty risk as overnight deposits. However, as term deposits are not marked to market they will not suffer any unrealised losses.
* Money market funds will see their yield rise in line with prevailing interest rates, although with a small time lag. However, because of their diversified portfolios money market funds carry significantly lower counterparty risks than overnight or term deposits. They are also not marked to market so are not exposed to unrealised losses.
* Short-term bond funds can earn higher yields than cash instruments, but their longer duration and marked to market pricing means that they are more sensitive to interest rate movements. Investors may therefore experience unrealised losses and so really need to be sure of the accuracy of their cash flow forecasting before investing in a longer-duration fund in a rising interest rate environment.
* Separate accounts offer investors the flexibility to tailor portfolios so that they have the risk and duration characteristics that they are comfortable with. However, separate accounts are marked to market and may therefore suffer unrealised losses as interest rates rise.
Measuring rate expectations
All portfolios carry an inherent level of interest rate risk. However, cash investors can monitor interest rate expectations by looking at the yield curve and the forward rates market to measure whether the level of interest rate risk in their current cash portfolios matches up with their risk tolerance in a rising rate environment.
With inflationary pressures beginning to build, most investors expect the major central banks to begin raising interest rates soon.
The yield curve can help investors gauge how the market views future short-term interest rates, because rates on longer securities are an average of current and expected future rates on short instruments. In normal markets the yields on securities with longer maturities are generally higher than for shorter maturities. The yield curve will slope upward, suggesting that interest rates are likely to rise at a relatively steady rate.
If the market expects rates to rise sharply, the yield curve will steepen as investors move into shorter maturities to avoid being locked into lower yields at the long end of the curve.
If the market expects rates to fall, then the yield curve may become inverted as investors opt for longer dated securities in order to lock in a better yield for as long as possible.
Investors can also use the interest rate futures market to try to forecast the direction of interest rates. The price of a two-year interest rate future shows the level at which the market expects interest rates to be two years from now. Futures can therefore also be useful in predicting interest rate movements.