Cash & Liquidity Management

Managing liquidity when interest rates are rising

Published: Nov 2018
J.P. Morgan Asset Management Thought for the Month – building stronger liquidity strategies – let's solve it.

November 2018

Rising rate environments can challenge even the most sophisticated fixed income investor. As the Federal Reserve (Fed) rate hiking cycle unfolds and regulatory reform kicks in, investors need to consider the implications for their short-term investments.

We are already starting to see the effects of the Fed’s policy, which is reflected across the Atlantic as the European Central Bank and Bank of England gradually unwind their fiscal stimulus. As the effects of the global financial crisis receded, the Fed chose to unwind its unprecedented policy cautiously at first, hiking rates only once in 2015 and again in 2016. However, since the beginning of 2017 it has raised rates six times and signalled further hikes in the coming years.

The 2018 hikes – in March, June and September – are expected to be followed by a fourth before the end of the year. Additionally, the Fed anticipates a further three in 2019, which will fundamentally transform the landscape for fixed income investing. If anything, the market has underpriced the scenario, meaning that if the Fed follows through with its own projections or acts more quickly than expected, many investors will be taken by surprise.

But why are rising interest rates such a cause for concern? Simply because when interest rates rise, the market value of previously issued fixed coupon bond holdings will fall, with investors’ interest shifting to newer, higher-yielding bonds. That said, not all securities are created equal. Assuming a stable credit environment, bonds with shorter maturities, floating interest rates and/or higher yields will prove far more resilient, and are likely to encounter less precipitous declines in demand and hence value.

So how should cash investors react to this new environment of rising global interest rates? An obvious solution to improve total returns from fixed income portfolios is to shift investments into shorter duration, higher-income-generating strategies, which may not necessarily entail significantly increased risk in the current stable credit environment.

As with all aspects of investing, forewarned is forearmed: careful study of past rising rate cycles and dynamic scenario analysis of potential future rate moves can deliver real insight and perspective, enabling the right investment decisions to be taken.

That said, nobody can predict the future with certainty. It is possible that improving economic data will persuade Fed Chairman Jerome Powell to take a more hawkish approach and accelerate the pace and scale of interest rate rises. Alternatively, evolving trade wars and a strengthening US dollar could lead to a slowdown in the normalisation process.

But whatever unfolds, shorter duration, higher income strategies should provide some relief – provided that decisions are informed by careful analysis of past events and deep understanding of the investor’s short-term cash needs and appetite for risk.

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