What happens when interest rates change drastically？

In the last 6 months, investors saw interest rates increasing at a unprecedented pace. The driving factor quoted has been “Inflation”. In fact, it almost seems as if bad thing is happening all the time, like the burnt turkey in the oven over Thanksgiving. These can attribute to inflation. , is accounted by is being. In reality, increasing interest rates is more akin to the FOMC's decision aims to kill the hope of parade and party.

Historical high interest rates back in...

Looking at this chart (USD Overnight rates), the rate was about 5.5% from 2006 to 2007, and then it quickly dropped to almost zero. This was done to improve liquidity due to the US sub prime crisis (more commonly known as the GFC).

And then interest rates started to peak again (around 2.25%), from 2016 to 2017, and again quickly dropped to near zero near in the end of 2019. Again, this was done to improve liquidity and save the world from the Covid 19 crisis. We seem to live in a dangerous world.

If you look at this chart that shows USD Overnight rates over the last 25 years, there is almost no incident instance of any sustained interest rate peaks.

This is a clear example that FOMC tends to over correct the market, mainly bacuase they rather be ahead of the curve then behind the curve. This means that they tend to try to kill a chicken with a cow knife (as the common Chinese saying goes) and then reduce the interest rate subsequently to suit the market conditions subsequently.

Have the rates hikes over-reacted again this time?

Well, it is unlikely. Given how inflation rates creeped up silently and suddenly surprised everyone, it was natural that the FOMC adopted all the available measures to quash it.

It is also unprecedented that the FOMC not only increased interest rates (we hear about this often enough), but they are also reducing the issuance of bonds as and when they it matures, targeting to reduce half a trillion dollars of liquidity from the market.

We cannot determine whether this is sufficient or not. But clearly, when the impact is felt in the market, inflation rates are going to crash down.

This reinforces the trend that there are no sustained interest rate peaks, because the FOMC tends to over correct the market. This represents an interesting opportunity. What can we do to take advantage of this?

The answer would be to lock in the high yield now, just as they start peaking.

1. We’ve talked about the danger lurking around the corner and when interest rates comes crashing down.
• This means that locking in high interest rates may not be a bad idea. It is probably a good time to start considering bonds as part of your portfolio.
2. Start investing in bonds.
• Bonds, especially those that was were issued in the past, are extremely likely to trade at below par value. Potentially, investors could add some of these bonds, and hold them till maturity. The coupon and the capital gain from the maturity of these bonds would be an interesting Return on Investment.
3. Short -term bonds rather than long- term.
• Obviously, we could be wrong in reading the market. Therefore, short-term bonds are preferred to long-term bonds. This is because short-term bonds are less likely to be affected by an interest rate hike, as they are not long enough for any multiplier effect. For example, a 75 bps rate hike will affect the price of a 10-year bond, more than it will for a 3-year bond.
4. Tech stocks thrives on terminal value discounts.

• Given the tech companies don't pay much dividend, the terminal value of the company is discounted over the market interest rate. As interest rates are increasing, the discounting factors becomes higher. Hence, what is likely to happen is that the same terminal value discounted over a higher interest rate, which will give us a lower present value. This is pretty much why the tech stocks have been dropping like dead flies, whilst the value stocks have not been as badly are not as much affected in the last 6 months.
• And given such an outlook, it actually may not be a bad idea to take profit on some of those long- term tech stocks that you have held and start allocating them into bonds.
• What you will get is a reduced volatility in your portfolio and regular income from the allocation.

Bond investments are unfortunately often very chunky. Meaning thatie typically, unless they are SGX- traded bonds, the minimum bite size is usually SGD 250,000. However, investors can look at investing in bonds through a fund. You should have a general view on the market trend. Or if you think you just want to hedge against the risk of a black swan event, you may consider setting part of your portfolio and letting a professional manage it via a bond fund.

Of course, you could also look at the United Fixed Maturity Bond Fund 1, which Tiger Brokers is launching with UOB Asset Management. The fund aims to deliver a return of 14.85% over the next three years, or an annualized return of 4.95%.

You can click here for more details.

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