Banks are raising interest rates even as investors have been piling into stocks – what happens now?

FORGET cryptocurrencies and cryptocurrency exchanges. With interest rates rising, the most exciting investment products at the moment seem to be savings and fixed deposit accounts.

This past week, even as heavyweight investors such as Temasek Holdings, Sequoia Capital and SoftBank Group counted the cost of their failed investments in FTX, OCBC made headlines with the launch of a 12-month fixed deposit product aimed at Central Provident Fund (CPF) members that pays 3.4 per cent per annum.

The fixed deposit product is being offered under the CPF Investment Scheme (CPFIS), which allows CPF members to invest in everything from stocks and bonds to unit trust funds and endowment policies.

This latest move by OCBC is a reflection of how much the investment landscape is being reshaped as major central banks tighten monetary policy to counter inflation rates that haven’t been seen in more than four decades.

It also underscores the importance of carefully rethinking all the financial arrangements we made when interest rates were very low, and updating our views as new economic data is published and financial market conditions change.

Of course, OCBC is not the only bank seemingly trying to position itself for a long period of higher interest rates. All three local banks have recently tweaked their savings account products to make them more attractive to depositors.

This past week, DBS, UOB and OCBC also raised their fixed home loan interest rates to more than 4 per cent – that is, above the interest rate floor set by the Monetary Authority of Singapore to determine the maximum amount an individual may borrow.

Still, the latest fixed deposit product from OCBC aimed at CPF members is particularly interesting.

Interest rates paid by CPF have been very hard to beat for many years. CPF Ordinary Accounts (OA) pay interest rates based on the three-month average deposit rates of the three local banks, subject to the legislated minimum rate of 2.5 per cent per annum.

CPF Special Account (SA) interest rates are based on the 12-month average yield on 10-year Singapore government bonds plus one percentage point, subject to a floor rate of 4 per cent per annum.

With the sharp rise in market rates over the past year, these minimum OA and SA interest rates now no longer seem so attractive. Indeed, the new OCBC fixed deposit could be a harbinger of CPF raising the interest rates it offers.

In particular, the SA interest rate could be on the brink of an adjustment. Since the beginning of this year, 10-year Singapore government bond yields have nearly doubled to more than 3.1 per cent.

Global markets rebound

Ironically, the upward adjustments to interest rates by Singapore banks came as stock markets were rebounding strongly.

The S&P 500 closed Friday (Nov 18) at 3,965.34 – up nearly 11 per cent from a recent closing low of 3,577.03 on Oct 12.

The S&P 500 even breached the 4,000 level during the trading session last Tuesday, though it slipped back below that key threshold before the close.

Closer to home, the Straits Times Index ended last week at 3,272.23 – up more than 10 per cent from a recent closing low of 2,969.95 on Oct 21.

The rallies in these market indices appear to have been at least partly driven by expectations of the US Federal Reserve and other major central banks slowing the pace of monetary policy tightening in the months ahead, as inflation pressures wane.

Indeed, the most recent US consumer price index (CPI) report on Nov 10 had a strong positive impact on global market sentiment.

The report showed that US CPI for October was up 7.7 per cent over the preceding 12 months, down from 8.2 per cent for September and 8.3 per cent for August.

Excluding the food and energy segments, the US CPI for October was up 6.3 per cent over the preceding 12 months, versus 6.6 per cent for September and 6.3 per for August.

Since this CPI report, however, some Fed officials have emphasised that they intend to push for continued rate increases. This past week, St Louis Fed President James Bullard reportedly said the federal funds rate ought to be raised to at least 5-5.25 per cent in order to be sufficiently restrictive.

On Nov 2, the Fed said it would raise the federal funds rate to 3.75-4 per cent – its fourth consecutive 75-basis-point rate hike. The next Fed meeting is scheduled for Dec 13-14.

Stocks not overvalued – yet

How does the recent market rally square with the Fed’s hawkishness? It is perhaps worth keeping in mind that interest rates have been rising from extremely low levels.

Back in May 2019, billionaire investor Warren Buffett created a stir when he said in an interview that he was surprised the prolonged period of low interest rates had not sparked a surge in inflation. If interest rates could remain at those low levels, he said, stocks were “ridiculously cheap”.

Buffett appeared to be comparing the US market’s earnings yield (that is, the inverse of the price-earnings ratio) to bond yields – a way of judging stock valuations sometimes called the “Fed model”.

By my calculations, the S&P 500’s earnings yield was about 2.2 percentage points above the 10-year US Treasury bond yield at the time – on the face of it, an indication that stocks were indeed attractively priced.

Buffett wasn’t making a bullish call on the market, though. He was flagging that interest rates, inflation and the state of the US economy were all somehow out of whack.

It was a prescient observation. After the pandemic turmoil and sharp tightening of monetary policy this year in the face of high inflation, the 10-year US Treasury bond yield is now more than 3.8 per cent, or about 130 basis points higher than it was when Buffett made his comments.

Meanwhile, the gap between the S&P 500’s earnings yield and the 10-year US Treasury bond yield had narrowed to just over one percentage point at the beginning of this month – suggesting the S&P 500 is still not overvalued, even if it is no longer “ridiculously cheap”.

Like Buffett back in 2019, however, I am not making a bullish call on the market. The way I see it, the market has still not fully adjusted to the current high level of inflation. Stocks are likely to look less and less attractive as the Fed continues tightening monetary policy.

Investors should use the current market rebound to position themselves for higher interest rates and weaker economic growth in the months ahead – perhaps by taking advantage of the relatively high deposit rates some banks are offering.