Interest Rate Cycles and Fixed Term Investments

Executive Summary

Interest rate cycles — the recurring pattern of central banks raising, holding and lowering official rates in response to economic conditions — have a direct and often underappreciated influence on fixed term investment decisions. The rates available on term deposits, bonds and notes at any given time are shaped in large part by where the broader interest rate cycle currently sits, and by market expectations of where it is heading. This article provides a general explanation of interest rate cycles and considers how investors might think about term selection and reinvestment risk across different phases of that cycle.

It is important to emphasise that predicting the precise timing or magnitude of future rate movements is inherently uncertain, and this article does not attempt to forecast the direction of any particular central bank's policy. Rather, it aims to explain the general relationships involved so that investors can better interpret the fixed term rates on offer at any point in time.

The Phases of an Interest Rate Cycle

In simplified, general terms, interest rate cycles can be described as moving through a tightening phase, in which a central bank such as the Reserve Bank of Australia raises its cash rate target in response to inflationary pressure or an overheating economy; a holding phase, in which rates are kept steady while the effects of prior changes flow through the economy; and an easing phase, in which rates are reduced in response to slowing growth, easing inflation, or other economic conditions warranting a lower rate environment. In practice, cycles do not always follow this idealised sequence precisely, and the pace and magnitude of movements can vary considerably between cycles.

• Tightening phase: official rates rising, generally flowing through to higher rates on new fixed term deposits and, over time, on newly issued bonds and notes.
• Holding phase: official rates stable, with fixed term rates broadly reflecting the prevailing level and market expectations for future moves.
• Easing phase: official rates falling, generally flowing through to lower rates on new fixed term deposits and new issuance over time.

How the Cycle Interacts with Term Selection

During a period when rates are relatively elevated compared with recent history, some investors consider locking in longer terms in an effort to secure that rate for an extended period, on the view that rates may subsequently decline. Conversely, during a period of relatively low rates, some investors prefer shorter terms, retaining the flexibility to reinvest at a higher rate should the cycle move into a tightening phase. It is important to stress that these are general considerations rather than predictions, and the future direction of rates cannot be known with certainty at the time an investment decision is made.

Investors cannot reliably time the peak or trough of a rate cycle in advance — general awareness of where the cycle currently sits can inform term selection, but it does not remove uncertainty about the future.

Reinvestment Risk Through the Cycle

Reinvestment risk refers to the possibility that, when a fixed term investment matures, prevailing rates are lower than the rate that applied to the maturing investment, requiring the investor to reinvest at a less favourable rate if they wish to maintain a similar allocation. This risk tends to be more pronounced for investors holding shorter-term investments during an easing phase of the cycle, since they face more frequent reinvestment decisions during a period of generally declining rates. Longer-term investments locked in before an easing phase can, in some scenarios, reduce this risk for the duration of that term, though they introduce the opposite risk during a tightening phase — namely, being locked into a lower rate while new rates on offer rise.

A laddering approach, discussed in more detail elsewhere in this series, is one general strategy some investors consider to moderate the impact of cycle timing, by spreading maturities across multiple dates rather than concentrating reinvestment risk at a single point in the cycle.

Key Considerations for Investors

• Recognise that fixed term rates on offer at any time generally reflect the current phase of the interest rate cycle and market expectations.
• Avoid basing term decisions on confident predictions of future rate movements, given the inherent uncertainty involved.
• Consider how reinvestment risk might affect your portfolio if rates move against you at the point of maturity.
• Review published central bank commentary and general market analysis as part of a broader, ongoing information-gathering process.
• Consider a laddering approach to moderate, rather than eliminate, the impact of cycle timing on a fixed term allocation.

Conclusion

Interest rate cycles exert a meaningful influence on the fixed term investment landscape, shaping the rates available at any given time and introducing reinvestment risk as terms mature. While the precise path of future rate movements cannot be predicted with confidence, a general understanding of how cycles function can help investors approach term selection with greater awareness of the trade-offs involved. This article is general information only and does not constitute personal financial advice; investors should consider their own circumstances and seek professional guidance where appropriate.

Related topics

Information contained within these insights is provided for general information purposes only and does not constitute personal financial advice, an offer or recommendation to acquire or dispose of any financial product. Investors should consider their individual circumstances and obtain appropriate professional advice before making investment decisions.