The recent Federal Reserve interest rate hike and the Bank of England's interest rate hike last month signal the beginning of the end of low rates in developed economies. Although many firms have benefited from past low borrowing costs, it is still possible for investors to profit from interest rate hikes which are expected in the future from the two countries.
The Bank of England's forecasted interest rate hikes
Increased borrowing costs
As the interest rate set by the central bank is the rate at which banks can borrow and lend from each other, a rise in this rate will increase borrowing costs for banks. This will benefit lenders while hindering borrowers and will have multiple effects on stock and bond markets.
Effect on stock markets
To keep up with rate hikes, banks that are net borrowers must raise their lending rates to its customers to offset these burdens, leading to less disposable income to investors. Additionally, since an increase in borrowing costs is imposed on other firms as well as banks, this also means they will have less capital to invest in positive NPV projects. Hence, lower expected future cash flows leading to a decline in growth and earnings.
Both effects of an interest rate hike will lead to a decline in stock prices of a company when considering the effects in isolation. However, banks that are net lenders and do not suffer from investors substituting away due to higher interest rates can benefit from rate hikes and, hence, higher stock prices.
Effect on bond markets
Due to the inverse relationship between interest rates and the price of bonds, rate hikes mean a decrease in bond prices. Rate hikes also decrease demand for low yield bonds, further decreasing prices for such bonds.
In other words, bonds are also a means for governments and firms to finance projects or sustain operations. A rate hike means higher borrowing costs and it is more difficult to issue bonds for new positive NPV projects. This means prices for such bonds must decline.
The Federal Reserve's decision to raise rates to 1.50% recently is expected to be followed by three rate hikes in 2018 and 2019. Sticking with this prediction, the time horizon for stocks or bonds in operating solely in the US is two years.
From the rate hikes, I recommend:
Shorting stocks with the following characteristics:
- US domestically operated firm
- High debt to equity ratio compared to its competitors
- Highly dependent on debt for operations
- E.g. Allscripts Healthcare Solutions (NASDAQ:MDRX), American Railcar Industries (NASDAQ:ARII)
Long stocks with the following characteristics:
- US domestically operated firm
- Operates in financial services
- Low debt to equity ratio compared to its competitors
- Independent or dependent to a low degree on debt for operations
- E.g. Franklin Financial Network (NYSE:FSB), Banc of California (NYSE:BANC)
Short bonds with the following characteristics:
- US government or corporate bonds
- Low yield bonds
- E.g. 3 Month Treasury Yield, 6 Month Treasury Yield
Recommended that US stocks and bonds have a holding period of two years.
The main exposure to the recommendations is when interest rates in fact fall or remain the same. Some strategies to counter this include:
- For the recommended shorted stocks
- Long call options on the stocks
- For the recommended longed stocks
- Long put options on the stocks
- For the recommended shorted bonds
- Long call options on the bonds
Another recommended hedging option can be a long commodities position to protect against a fall in interest rates. For example, a long position in gold or crude oil can hedge against a fall in interest rates.
The inverse relationship between interest rates and commodities over time
As interest rates rise in the near future, it is important for investors to prepare for stiffer borrowing costs.
- Companies with poor debt management are more likely to suffer than those with those with superior debt management
- Results in stock prices for such firms to fall and rise respectively
- Taking a short position in stocks with firms with large debts and a long position in stocks with firms with smaller debts will be profitable
- Those with lower yields will suffer from interest rate hikes
- Cost of borrowing is higher and demand for lower yield bonds and prices for such bonds declines
- Taking a short position in low yield bonds will be profitable
It is also important to hedge these recommendations through a variety of options positions and a long commodities position.
Bill Zhong helped proofread and provide advice for this article.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.