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What would happen if interest rates started rising?

What if interest rates started rising again?

It seems unthinkable at a time when rates are at the lowest they’ve ever been. The Reserve Bank of Australia (RBA)’s official cash rate is currently sitting at 0.75% and many are predicting we could see at least one more cut by this time next year, as you can see in the graph below:

Source: ASX

But at a level of 0.5% or even 0.25%, there’s only one direction rates can really go from here – and that’s up. Therefore it’s not a question of if, but when.

What would cause a rate rise?

Although there are many factors that the RBA analyses when considering a move in interest rates, the main catalyst would be inflation. The RBA (like most central banks) has controlling inflation at the top of its mandate, with a target band of 2–3% set in Australia. As it happens, Australia’s inflation hasn’t reached that band for years, and has in fact been dangerously close to zero for a few years now – which partly explains why rates are currently so low.

But if inflation was to pick up across the global or Australian economies, the RBA would probably have little choice but to raise rates again. Therefore, the inflation rate is something I keep a close eye on personally.

What would higher rates mean for investors?

In short, it wouldn’t be pretty. A higher cash rate translates into higher government bond yields. A government bond is known as a ‘risk-free’ investment (as an advanced-economy government can never really default on its debt due to its ability to endlessly print money).

This ‘risk-free’ rate is used to measure all other assets against, so if this rate rises, the intrinsic value of other risky assets like houses and shares will fall in the eyes of most investors. One of the reasons our share market is at record high levels is because of the extremely low risk-free rate we are currently enjoying. But if this was to reverse, its likely we would see a substantial correction on the ASX.

Foolish takeaway

Whilst I don’t expect interest rates to rise anytime soon, they very well could. Therefore, I think it always pays to have a think about what could happen in the economy and how that could affect your portfolio. It is for this reason investors should (in my view) think of stocks as quality companies to own, rather than a means to a yield.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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