As interest rates rise, what is the big picture?
While the BoE increased interest rates by 25 basis points today, the yield on UK gilts has fallen as BoE Governor Mark Carney expressed confidence in the Bank’s ability to return inflation practically to target over the next three years with only two further increases in interest rates.
As of last night, markets were expecting the same number of interest rate increases in the UK and US over the next three years. We believed that future moves from the two central banks were unlikely to be so similar, and had moved much of our US Treasury exposure into UK gilts. We view risks in the US as being to the upside as the US government seeks to reduce tax rates for companies and individuals, while in the UK the economy has remained resilient despite a poor start to negotiations about the UK’s future relationship with the European Union (EU).
Looking more closely at the BoE’s decision today, it feels like the MPC is taking the opportunity to try and restore its inflation fighting credibility and to unwind the post-EU referendum interest rate move (dare we say it – error). The reduction last year likely exacerbated the fall in sterling, pushing up inflation. The expectation of a reversal today has helped to boost the pound over the last two months, which should in turn help deliver inflation back towards the 2% target from 3% in September. A higher interest rate also gives the Bank more room to reduce interest rates should we see a negative shock to the economy, such as from a poor outcome from leaving the EU.
The Bank also seemed to confirm that the MPC shares a similar interest rate outlook to the markets (a hint of forward guidance perhaps?), which are pricing in a very slow pace of interest rate increases. Keeping interest rates low suggests that sterling is unlikely to appreciate significantly as short-term yields have been an important driver of currency movements in recent years. A relatively weak sterling should continue to support the FTSE 100 Index and overseas equity positions, while low interest rates should result in gilt yields remaining subdued.
Basis point = a unit of measure used to describe percentage change. One basis point is equivalent to 0.01%.
Bond yield movements = bond yields move inversely to prices; if bond yields fall, prices rise, and vice versa.
Dovish = when monetary policy is dovish, it means that policymakers favour more accommodating policy, because they want to stimulate growth in the economy. One of the key ways to accomplish this is keeping interest rates low.
Forward guidance = a more explicit statement from a central bank regarding the future conduct of monetary policy.
Inflation = the rate at which the prices of goods and services are rising in an economy. Rising inflation typically causes bond prices to fall.
Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
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