• Financial markets are currently pricing in a 95% chance of a UK interest rate rise to 0.5% next Thursday
• Also priced in are a total of four interest rate hikes this year, taking base rate from 0.25% to 1.25%*
• If realised, that would take interest rates to their highest level since February 2009
• An estimated 10 million Britons have never seen base rate above 1% in their adult lives**
• But this wouldn’t be the first time markets have got ahead of themselves when it comes to predicting interest rate hikes
• The impact of rising interest rates on funds, markets and investors
*sources: Refinitiv
**sources: AJ Bell, ONS
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“It’s not just in the US where the prospects for tighter monetary policy are escalating, markets are also expecting a significant number of rate hikes in the UK this year. A rate rise at the Bank’s February meeting is all but inked in, which if realised would be the first time since 2004 that the bank has raised interest rates in two consecutive meetings. Market pricing suggests a further three hikes this year, taking base rate to 1.25% by the end of 2022, which would be its highest level since February 2009, just before an ‘emergency’ rate of 0.5% and QE were introduced.
“Rampant inflation is of course the reason markets are now expecting the Bank of England to start pressing on the monetary policy brakes. It’s a startling sign of how dramatically the economic outlook has changed in the last twelve months to consider that this time last year, the rate setting committee was talking about a negative base rate in the UK. Fast forward to 2022, and the market is thinking four rate rises could materialise this year alone.
“This would be a paradigm shift for investors, businesses and consumers, all of which have become accustomed to a prolonged period of extremely accommodative monetary policy. Indeed we estimate that 10 million people in the UK haven’t seen base rate above 1% in their entire adult lives. Little wonder then, that markets are getting in a bit of a tailspin about what rising interest rates might mean for stocks and bonds. The Chancellor might also be squirming in his seat. Higher base rate will mean the Exchequer needs to pay significantly more interest on the £875 billion of gilts held in the QE scheme, and that could have significant implications for the viability of any largesse the Chancellor might like to indulge in at the March Budget.
“Market pricing can change pretty quickly, and of course, this wouldn’t be the first time markets have got ahead of themselves when it comes to betting on rate rises that never materialised. Last November, markets were certain we were going to get a rate hike, but seven out of nine committee members voted to keep rates on hold. Today though, consistently high inflation and a buoyant labour market make a prima facie case for tighter monetary policy, and having raised rates in December, the Bank’s policy setting committee has some momentum behind it.
“The Bank of England can’t control the major factors that will push inflation up in the immediate future, such as global energy prices or elevated shipping costs. But a February rate hike would help persuade the market that the Bank really means business, and help to stave off embedded inflationary expectations that could spark a dreaded wage-price spiral. A rate rise would be doubly significant because base rate would cross the minimum 0.5% threshold the Bank of England has set before it considers unwinding the QE scheme, which opens the door for Quantitative Tightening to take place. If you’re a long-dated gilt investor, you might want to hold on to your tin hat.
“Over the course of the rest of the year the Bank may prove more circumspect than the market is currently anticipating. There could yet be some relief from inflationary pressures later in the year if supply chains normalise and energy prices fall back, perhaps for instance if there is a peaceful solution to the Ukraine crisis. The Bank may also want to see how the effects of tighter policy play out in the economy for a while, before cranking the handle too many times in a row. Nonetheless, 2022 does look like it’s going to be the year when the monetary policy worm finally turns, and that will have wide ranging implications for consumers, businesses and markets.”
The 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 probably a better place to be than bonds in a tightening cycle though, and at least offer some 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 final 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 have already seen the US tech sector sell off in the last month or so, as expectations of tighter monetary policy 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 would likely 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 is still trading close to its record high seen last year. However, not all smaller companies carry significant levels of debt, and while these businesses aren’t immune from what’s going on in the wider economy, the drivers of growth can be more secular and idiosyncratic. That can help share prices recover strongly when market sentiment improves. Indeed, the long term performance of this section of the market has 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 might also prompt withdrawals 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 gilt yield rising from 0.3% at the beginning of last year to 1.2% today. 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. So if the Bank of England raises rates, the Exchequer will feel the burn.
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. 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 low yield in return. Longer dated bonds can be expected to see the biggest price falls if policy tightens, as they are more sensitive to interest rate rises.
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. 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 in theory 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 still struggle to post positive returns, particularly after tax and charges.
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. Investors may still turn to gold though, if they buy into the idea that it’s a hedge against inflation.
Moneymarket funds – these cash-like funds saw £1.6 billion of inflows last 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 may see more money heading into moneymarket funds as such investors seek sanctuary from rising rates. Higher rates should lead to higher yields in the moneymarket sector, but like cash, the ascent is likely to be painfully slow compared to the rate of inflation.
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 cash rates, so higher 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.
