- Andrew Bailey talks up an interest rate hike
- Markets are now pricing in an 85% chance of a UK rate hike by Christmas*
- Around 10 million Britons haven’t seen interest rates above 1% in their adult lives**
- The impact of rising interest rates on funds, markets and investors
*source: Refinitiv 18/10/2021
**sources: AJ Bell, ONS
Laith Khalaf, head of investment analysis, AJ Bell:
“The market is now expecting an interest rate hike by Christmas, largely thanks to the inflationary pressures which will inevitably follow the energy crisis, and some markedly hawkish rhetoric from the governor of the Bank of England. According to interest rate markets, there is now an 85% chance of a rate rise this year, and a 60% chance of a hike at the next MPC meeting in November. Markets are pricing in tighter policy because the energy crunch could prompt a dramatic U-turn on interest rate policy at the Bank of England.
“There does certainly seem to have been a significant shift in rhetoric coming from the Bank, but there may yet be some prevailing factors which push an interest rate rise into next year. The Bank’s rate setters will want to see what the economy looks like after the sticking plaster of furlough has been properly removed, and how much legs the energy price crunch has left. The Bank may well be wary that rising energy costs will act as a brake on economic growth, which will do a similar job to an interest rate hike, thereby alleviating the need for tighter policy just yet.
“There’s also the human element to consider. The Bank’s interest rate committee voted unanimously to keep interest rates on hold less than a month ago, so a 2021 rate rise would require a pretty humbling collective shuffle across the aisle. It’s also important to note that elevated inflation right now doesn’t necessarily undermine the Bank’s stated view that it is transitory. As of their last forecast, the Bank was expecting inflation to rise to 4% this winter, and still be 3.3% in Q3 of next year, and that elevated level was consistent with a rate rise only in the back end of 2022.
“Even if we don’t get a rate hike this side of Christmas, tighter monetary policy is firmly on the agenda in financial markets. Savers and investors should therefore take stock of their finances, because an environment of rising interest rates is going to be a shock to many. Indeed a whole generation of young adults won’t even remember a time when bank rate started with anything other than a zero. Around 10 million people in the UK haven’t seen interest rates above 1% in their adult lives, seeing as the last time base rate was at this level was in February 2009.
“The next interest rate decision takes place on the 4th November in the UK, just one day after the more influential Federal Reserve will announce its stance on tightening US monetary policy. Guessing how nine people in a room are going to vote on interest rate policy isn’t based on any science, but a rate hike in November would give the impression of a pretty panicked knee-jerk reaction to events unfolding in the energy market. A December hike therefore looks more likely, but there’s still a lot of data to enter on the Bank’s spreadsheet before then. When the time comes, the central bank will want to take a slow and low approach to tightening policy, so as not to cause any frogs to leap out of the simmering pan. Market prices will move ahead of the Bank of England however, which goes some way to explaining why gilt yields have more than doubled in the last two months.”
Impact of rising interest rates on funds, markets and investors
Equity investors – equities won’t take kindly to an interest rate hike in and of itself, but rising interest rates are a sign the economy is in more robust health, and that should be good for corporate earnings. The worst case scenario for equity markets is stagflation, where interest rates rise simply to fend off inflation, but the underlying economy is going sideways, making it harder for companies to grow their sales. Equities are a better place to be than bonds in a tightening cycle however, and at least offer protection from inflation over the long term, which should help to underpin share prices.
Indebted companies - a rate hike would increase the interest bill paid by companies on their borrowings, so those with largest debt piles would find their earnings worst hit. Pension contributions for legacy finance salary schemes could also rise, as these are linked to bond yields. These effects would likely take some time to feed through, as pension funding is reviewed only once every three years, and corporate debt refinancing at higher rates will also take place gradually over a number of years as cheaper, older debt matures, to be replaced with more expensive borrowing.
Tech and growth stocks - more immediately, stock valuations might get clipped back by a rise in the risk-free rate - determined by government bond yields, especially in the US. Those companies with valuations based on more distant earnings streams, like some tech companies, would find themselves at the sharp end of proceedings, and in fact we already have seen the US tech sector sell off in the last month or so, as US bond yields have risen.
‘Bond proxies’ - would also likely see share prices come under pressure, as investors are tempted out of companies like Unilever, Johnson & Johnson and the utilities sector, and back into their natural habitat of bonds, as yields rise and therefore offer better relative returns. The share prices of these companies have done exceptionally well in a low interest rate environment, but they will find the going gets tougher if monetary policy tightens.
Banking sector - higher interest rates should be good for banks. The ultra-low interest rate environment has compressed the interest margin between deposits and loans, which are a bedrock of profits for commercial banks. Bad loans shouldn’t tick up too much, as any interest rate rises are going to be very gradual. The slow pace of tightening policy means bank profits aren’t going to skyrocket overnight, but shares may well appreciate as the market prices in a better monetary backdrop for the sector.
Smaller companies - in theory, smaller companies are more fragile than their blue chip cousins, as they have less robust earnings streams and access to capital. In some cases, higher interest rates would increase their debt burden, and could push them further towards the cliff edge of losses and insolvency. Their stock prices are often predicated on longer term growth too, and so higher interest rates and inflation could mean we see some valuations pegged back. That’s particularly the case seeing as the UK’s small cap index has been hitting record highs of late – the FTSE Small Cap is up 43% in the last year, compared to 23% for the FTSE 100 (source: AJ Bell, FE, total return to 12th October 2021). However, not all smaller companies carry significant levels of debt. And while smaller companies aren’t immune from what’s going on in the wider economy, the drivers of growth are more secular and idiosyncratic, which can bolster share prices even in troubled times. The long term performance of this section of the market has also been exceptionally strong, particularly when partnered with active fund management.
Residential property - higher mortgage rates should take some of the steam out of the housing market. Prices could fall, but a moderation of price growth seems more likely, given the ongoing imbalance between supply and demand, and the presence of continued government support in the form of Help to Buy and the Mortgage Guarantee scheme. The Bank of England certainly won’t want to put so much strain on the economy that homeowners are posting their keys through the letterbox as they leave, because they can’t afford mortgage payments.
Commercial property – commercial property prices could also come under pressure from interest rate rises, which heap pressure on tenants by increasing their debt bills. If the economy is in fine fettle though, that should mean businesses can afford the extra costs, though the good times may not be split fairly amongst all sectors. As an asset normally held for income, the commercial property sector may see outflows if bonds and cash start offering a more attractive yield. That could spell more trouble for the open-ended funds invested in commercial property, where large outflows might increase the risk of trading suspensions. The sector is already on tenterhooks waiting for the FCA to announce if notice periods will become mandatory, which could also prompt an exodus from the sector.
Taxpayers - rising interest rates would also be extremely negative for government finances, and by extension, the taxpayer. Government bond prices have already adjusted to the prospect for higher inflation and tighter policy, with the 10 year yield rising from 0.5% to 1.1% in just two months. In ‘normal’ conditions, rising rates only affect new government borrowing, but today, the QE programme has effectively pegged £875 billion of government debt to the base rate. This is a floating rate that can change interest payments overnight, unlike the fixed rates of the gilt market. In its Budget forecasts in March, the OBR estimated that if interest rates were 1% higher, that would add £20.8 billion to the government’s debt interest bill in 2025/26. To put that in some context, that would wipe out all the £8.2 billion gain the Treasury expects from freezing income tax allowances, as well as a sizeable chunk of the £17.2 billion projected to roll in from the rise in corporation tax.
Gilt investors - conventional UK government bonds are directly in the firing line if monetary policy tightens, either through interest rate rises or an unwinding of QE. Some UK gilt funds have already sustained double digit falls so far this year, and the average UK gilt fund has lost 8.8% (source: AJ Bell, FE, total return to 12/10/2021, Investment Association UK Gilt sector). While that’s probably not enough to make most equity investors blush, investors choose bonds because they’re seen as safe havens. But twelve years of ultra-loose monetary policy has driven gilt prices so high, they now carry an awful lot of valuation risk, and offer a desultory yield in return.
Pension lifestyling fund investors – a subset of gilt investors, these investors are particularly at risk as they will probably never have made an active choice to invest in bonds. As these investors approach their stated retirement date, they are automatically shifted from equities into long dated government bonds. The idea is to hedge annuity rates, which move in line with bond yields. Of course, since the pension freedoms were introduced, very few people now buy an annuity. But these lifestyling programmes, potentially set in train 20 to 30 years ago, are still robotically moving people into gilt funds nonetheless. These lifestyling funds have lost on average 11.6% so far this year (source: AJ Bell, FE total return to 12th October 2021). Any falls sustained in the value of these funds should be offset by rising annuity rates. But then, that’s not much use if you’re not buying an annuity.
Corporate bonds - Unlike gilts, corporate bonds (both investment grade and high yield) carry a higher interest rate, which helps cushion the impact of price falls emanating from fears of tighter monetary policy. They also tend to be shorter dated, which means they are less sensitive to interest rate rises. Being loans to companies rather than governments, they also experience some upward pressure on prices from an improving economy, because the accompanying earnings growth should make it easier for companies to service their debt. In a rising interest rate scenario, these ‘riskier’ bond funds should therefore fare better than ‘safer’ gilt funds, but they still might see negative returns.
Gold investors – higher interest rates aren’t good for gold because it pays no income. That’s much less of an issue when rates are close to zero, and so the opportunity cost of holding an asset with no yield is virtually nil. As interest rates rise, that cost becomes heavier to bear, and cash and bonds become more attractive as safe havens. It’s interest rates in the US which are more important to the gold price than in the UK however. The gold price peaked at over $2,000 an ounce last summer, and has now fallen back to around $1,750, as market optimism has lessened demand for safe havens.
Moneymarket funds – these cash like funds saw £1.6 billion of inflows in August, which is more than they see in most years. Most of that can probably be accounted for by cautious multi-asset funds fleeing bonds, and in the short term we can probably expect to see more money heading into moneymarket funds. Rising interest rates should lead to higher yields in the sector, but like cash, the ascent is likely to be painfully slow, so, it’s going to take a number of rate hikes before these funds offer a reasonable rate of return, particularly when you take charges and inflation into account.
Absolute return funds - rising interest rates are a double edged sword for absolute return funds. These funds tend to hold large sums of cash to offset derivative positions, and so higher rates will feed through into more interest flowing through into returns. However, the target return for many funds is based on LIBOR, so rising interest rates will mean many absolute return funds have a higher hurdle to clear to beat their benchmarks, and potentially collect the performance fees which are common in the sector.