It has been more than a decade since the last interest rate tightening cycle. As we dust off this report written more than ten years ago for corporate treasurers on how to weather a rising rate cycle, we are struck by how little we needed to revise its content despite a vastly different cash investment landscape today.
What’s Different and What’s Not
Despite a few false starts, it appears that in a few weeks the time may finally be here for the Janet Yellen Fed to start increasing interest rates. While the short-term investment community aches to break the spell of the near zero interest rate policy (ZIRP), higher rates can be an unpleasant experience if not taken seriously.
All else being equal, higher rates result in immediate unrealized losses in existing holdings. Credits may see more losses than government securities because of inherently higher risks. This normally isn’t a big concern if one intends to hold securities to maturity, assuming that the terms are short and credit quality is high. However, it may be problematic if one has to sell assets prior to maturity and turn unrealized losses into realized ones. These risks remain the same from one rate tightening cycle to the next.
What’s different in this cycle is that unprecedented quantitative easing to combat deflationary forces has left global central banks with unusually large balance sheets. In the U.S., the effectiveness of the fed funds rate as the main tool to lift all other rates is in doubt, as deposit-rich banks have little need to borrow in the fed funds market. Though the U.S. economy appears healthy, the same cannot be said about Europe and China. The Fed’s tightening will come in contrast with more qualitative easing in these regions. The Fed’s decision to reinvest cash proceeds from its treasury and agency mortgage bond holdings while raising rates also complicates matters.
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