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Interest Rates - Has The Worm Finally Turned?

There is no doubt, ever since Don Brash as Governor of the Reserve Bank finally managed to get inflation and inflationary expectations under control in the early nineties, New Zealand has been in a long term bull market for bonds. The market value of bonds goes up as interest rates fall. A simple way to understand this is as follows. A bond issued when interest rates are high, still pays that same high interest rate even when interest rates fall. The market then ‘adjusts’ the value of a fixed rate bond to reflect that bonds of similar risk would now be issued  with a lower interest rate, so the current bond trades  at a value higher than its issue price (normally $1). This is what is meant when a bond is described as ‘trading at a premium’.

The trend of lower and lower rates, barring occasional increases, has been experienced for in excess of 25 years, and was further exacerbated by the Global Financial Crisis (GFC). In the wake of the GFC, Reserve banks around the world, particularly in developed economies, aggressively pursued extremely low interest rate policies in an attempt to foster growth and employment following the recession. However, an unintended consequence of aggressive rate cuts in a limited number of countries was negative interest rates.

As a result of these events, bonds and fixed interest securities, which traditionally have been primarily owned as ‘safe haven’ investments, have actually returned equity type returns as interest rates fell lower and lower.

But nothing lasts forever, and it appears that this generational long term trend may finally be turning, led by the USA. On the back of a strengthening economy, the Federal Reserve has indicated interest rates are set to rise, with the market anticipating a rate rise at the next Fed meeting in mid-December.

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