What makes markets happy: an interest rate cut, followed by signs that there are more to come.
The simple reason is that when interest rates are raised, company earnings will be affected by higher interest costs, resulting in stock prices being hit.
Sometimes, other interest-bearing instruments might become more attractive, leading investors to switch out of stocks into those instruments.
Whatever the case, the simple truth is that the stock market doesn’t like raising interest rates and so would certainly celebrate when rates are lowered.
In mid-February 2024, the US stock market has already risen to several all-time highs since the start of the year in anticipation of the US Federal Reserve cutting interest rates sometime soon.
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Recall that the reason the Fed raised rates aggressively 11 times between March 2022 and July 2023 was to rein in surging inflation which was hovering around an annual rate of 8% at its peak.
As such, the current push on US stocks since the end of 2023 comes from the latest US consumer and producer price data, which shows that inflation is moderating and is heading down, though not yet to the Fed’s 2% target.
Added to this is that the Fed has kept rates steady at 5.25-5.5% since July 2023, long enough to suggest that the US central bank is, at the very least, done with its rate hikes.
When will interest rates be cut?
When the Fed will actually lower interest rates is of course, anybody’s guess.
The Bank of Singapore (BOS) said it thinks the first interest rate cut will come in June, followed by cuts in September and December.
Morgan Stanley, meanwhile, said it expects four quarter-point cuts totalling 1% starting in June.
Until the first week of February, there were hopes that the first interest rate cut might even come in March, though Fed chair Jerome Powell has recently taken great pains to signal that this isn’t likely.
No matter, the wave of optimism that has gripped markets over the past few months isn’t going to fade any time soon, because as far as Wall St is concerned, it’s not a matter of “if” but “when”.
This then leads to the logical next question – other than stocks, what would benefit most when interest rates are actually cut?
Bonds will likely benefit from interest rate cuts
You might have heard that bond prices and yields move inversely, i.e. in opposite directions. If you’re wondering why, the explanation is simple.
Bonds, which are basically borrowings by governments or companies, pay regular interest known as coupon payments on the face value. The face value is always in multiples of $100 so if a bond’s coupon is 3% this means that the holder who paid $100 will receive $3 annually.
The yield, which is the return, is given by the simple formula:
Yield = Coupon/Price, which in this case is $3/$100 or 3%.
Now suppose this bond is traded in the market and someone pays $101 to buy it.
In other words, since a higher price was paid, the yield will be lower.
Similarly, if a lower price is paid, the yield will rise – all because the coupon payment is fixed. This is why bond yields and prices always move inversely.
Suppose interest rates now rise by 1%.
In order for this bond to remain competitively priced, it has to yield at least 4%, in which case, its price will fall because:
- If Yield = Coupon/Price, then Price = Coupon/Yield.
- So, if the yield the market demands is at least 4%, the price will have to be around $3/4%, which is $75.
- If, however, interest rates fall by 1%, this bond will be in demand and its price will rise to $3/2% or $150.
An interest rate rise has led to a fall in the price and conversely, a fall in interest rates has resulted in a price rise.
Since rates are expected to fall in 2024, this is why most market strategists are recommending investors buy bonds.
Why bonds with long maturities?
In January, BOS advised its clients to consider bonds with longer maturities, around 8-15 years.
If you’re wondering why, the reason is that if interest rates fall, bonds with longer maturities offer the greatest price gains as compared to bonds with shorter maturities.
The explanation is simple. Suppose you have two bonds that pay the same coupon, but one has 20 payments left whilst the other has only one left.
If interest rates rise or fall by say 0.25%, the market will adjust the prices of both accordingly. But a 0.25% adjustment of 20 payments will be much greater than 0.25% of one payment.
So, it makes sense if you think interest rates are going to fall, to buy bonds with longer maturities to enjoy the maximum price gains.
Why bonds with low coupons?
By the same token, bonds with low coupons tend to react the most to interest rate changes.
Consider two bonds with the same maturity but one pays a coupon of 2% and the other 4%.
If interest rates fall by 0.25%, the market will adjust both prices upwards. But a 0.25% adjustment will have a greater impact on the bond with 2% coupon than on one which pays 4%.
To illustrate:
Since Price = Coupon/Yield,
Adjusted price of the 2% bond will be $2/1.75% = $114.28.
Adjusted price of the 4% bond will be $4/3.75% = $108.67.
Therefore, it makes sense if you believe interest rates are heading lower, to buy bonds with low coupons so as to enjoy maximum price gains.
To summarise, bonds with low coupons and long maturity dates can be expected to rise the most when interest rates are lowered.
What about Real Estate Investment Trusts?
The other type of instrument which could benefit from lower interest rates are real estate investment trusts or REITs.
These are basically landlords that collect rents from tenants and distribute the money to their shareholders, or to use the correct terminology, their unitholders.
All REITs tend to have large borrowings since owning and buying buildings such as retail malls, hospitals, office buildings, warehouses or hotels tend to require large capital outlays.
As such, heavy interest costs have weighed heavily on profits in 2022 and 2023 and kept a lid on REIT prices.
However, now that rates are expected to fall, it makes sense that the sector could see renewed interest due to improved earnings.
Which REITs?
Throughout the Covid-19 pandemic, it is perhaps not surprising that healthcare REITs were the best performers.
Also in demand were data centre REITs, because of the increased demand for digital technologies. Not surprisingly given the shutdowns, retail mall and office REITs fared poorly.
Now that economies have reopened and travel has resumed, hospitality REITs should do well, together with office REITs – provided of course, the majority of workers return to working in an office instead of working from home.
For first-time investors, best to focus on Singapore-based REITs first
Although there are many REITs listed on the Singapore Exchange that offer exposure to overseas markets such as Indonesia, China, Australia, Europe and the US, our advice would be for first-time investors considering REITs to focus first on those based mainly in Singapore so as to avoid foreign currency transaction risks.
Furthermore, concentrating first on locally-based REITs offers the advantage of familiarity – you can actually visit some of the premises to check on how well-occupied they are.
Also, much of how a REIT performs depends on the parentage, namely the sponsor and the manager.
There are several which are majority-owned by Temasek Holdings, which although is no guarantee of superior performance, should provide assurance that they are at the very least well-managed and well-governed.
Strong, reputable parentage should also minimise loss through questionable accounting or transactions.
