April 15, 2024

Have we reached Peak Interest Rates? Why it matters

Peak interest rates provide an ideal opportunity to review your fixed income investments and set your strategy for a turn in the interest rate cycle

Peak interest rates

In the world of fixed-income investments, yields play a crucial role in determining the value and performance of bond portfolios. As an investor, it’s essential to understand how yields are impacted by peak interest rates and how it can affect your investment strategy.

Peak yields refer to the highest level that interest rates reach before stabilising or declining. They are often the result of aggressive monetary policies, where central banks raise rates to combat inflation or cool down an overheating economy. When yields are at their peak, it indicates a turning point in the market cycle.

Have we reached a peak in yields?

According to the NAB rates strategy team, interest rates have now peaked, and we are likely to see the first rate cut in November 2024, with a gradual cutting cycle to 3.1% by end 2025 (forecast current as of April 2024). If their forecast is correct, the overnight cash rate moving lower means investors who keep their savings in cash are likely to see lower returns as interest rates fall.

Meanwhile, the Australian 10-year yield has been range bound year to date, between 3.82% and 4.35%. Long end yields have traded towards the lower end of the range on what has been generally weak economic data, meanwhile the recent strong labour market data has shifted long end rates back to the upper end of the range. While near term we could see long end yields remain range bound, the NAB rates strategy team do expect the AU10Y to eventually break to the downside in 2025 (forecast of as April 2024).

The relationship between yields and bond prices

There’s an inverse relationship between bond yields and bond prices. When yields peak and eventually decline, fixed bond prices rise, and vice versa. This is because new bonds are issued with lower interest rates, making existing bonds with high rates more attractive. Therefore, the price of existing bonds rise as the higher interest they pay becomes more attractive.

When yields reach their peak, investors should consider a few factors.

  1. Reinvestment risk: If you are currently keeping your savings in cash or term deposits and enjoy a high rate today, you might want to consider what happens when your term deposit matures. If rates are lower, then you will be renewing your term deposit at a lower rate. One way to avoid this issue is by entering a longer-term fixed rate bond today before yields decline.
  2. Fixed bond prices: As yields approach their peak, bond prices bottom and as interest rates move lower, bond prices rise. This means that investors who purchase a fixed bond today could see price growth in the value of their bond in addition to the fixed yield earned.
  3. Opportunity cost: Holding onto lower-yielding assets when yields are peaking means missing out on higher interest rates offered by new bonds.

Strategies for managing peak yields

For investors who agree that interest rates have peaked and are looking to take advantage of this turning point, consider the following strategies:

  • Duration management: Lengthen the duration of your portfolio to increase sensitivity to interest rate changes. Investing in longer-term bonds can provide the potential for more bond price appreciation.
  • Diversification: Spread your investments across various maturities and credit qualities to mitigate the impact of yield fluctuations.
  • Laddering: Create a bond ladder by purchasing bonds with staggered maturities. This approach allows you to benefit from higher yields as you reinvest maturing bonds.
  • Active management: Employ an active bond management strategy to adjust your portfolio in response to changing yields. This may involve selling certain bonds before maturity to capitalise on price movements once interest rates move lower.

A peak in interest rates is a critical factor to consider in bond portfolio management. By understanding their implications and employing strategic measures, investors can protect their portfolios from adverse effects and potentially capitalise on the opportunities presented by fluctuating interest rates.

 

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