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First Rate

Summary

Much conjecture surrounds the timing of the first rate hike in the current economic cycle in the US and the UK. Equity and debt markets have oscillated meaningfully on such speculation. I was at a lunch when a competitor was talking about how it was his focus. The reality is a little different. While short term traders may care about the daily machinations of central bank monetary policy, for longer term investors, it’s just noise. We know that barring an unforeseen incident, interest rates are going to normalise on the back of decent economic data in the US and UK as predicted below in the interest rate futures chart below.

Much conjecture surrounds the timing of the first rate hike in the current economic cycle in the US and the UK.  Equity and debt markets have oscillated meaningfully on such speculation.  I was at a lunch when a competitor was talking about how it was his focus. The reality is a little different.  While short term traders may care about the daily machinations of central bank monetary policy, for longer term investors, it’s just noise.  We know that barring an unforeseen incident, interest rates are going to normalise on the back of decent economic data in the US and UK as predicted below in the interest rate futures chart below.

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The Bank of England, through its excellent network of regional agents, has been happy to point out that it believes the futures market to be right in its view of likely interest changes and direction.  What is perhaps more interesting is that the Bank is also convinced that inflation will be back at 2% in 2017.  This would suggest that we’ll still have negative real short term interest rates in 2017 as inflation will be below short rates by around 0.5% depending on what part of 2017 you choose.  Even if that is the case, ten year maturity UK government bonds currently yielding 1.57% on this the last day of March, look expensive.  They may look cheap to a European bond investor as German ten year equivalents yield just 0.20% but if UK inflation is going to be 2% in 2017, ten year gilts could be yielding around 2% more which translates into a considerable fall in their price.
It would appear that the current government agrees, in his recent budget, Chancellor George Osborne said that the Treasury would be issuing long dated government bonds, presumably while it is still very cheap to borrow money – thirty year rates are currently 2.32%.  No wonder there’s concern in UK government and non-government bond markets that if everyone heads for the door at the same time, mayhem will ensue.
Be careful out there, interest rates look set to rise gradually from here.  The timing of the first rate hike from the Bank of England may use up some column inches but longer-dated bonds may well be more volatile than investors have recently become used to.

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