Jonathan Marriott, Chief Investment Officer
During the Budget this week, Rishi Sunak said he had written to the Bank of England (B of E) confirming its continued mandate for stable prices. At the onset of the economic crisis created by COVID-19, there was a view that policy makers would adopt monetary financing. This involves large fiscal giveaways funded by a loose monetary policy that would suppress government bond yields. To a degree this has happened. However, given the wider concerns surrounding inequality and cost of climate change policies, the Chancellor’s approach was more fiscally conservative at the budget, than the above view would indicate.
As we addressed in our article two weeks ago, Will inflation drive UK interest rates higher?, the dilemma facing the BoE is one of significance. Nevertheless, the market is pricing in a higher chance of rate hikes in the near term. Two-year gilt yields have risen from 0.40% to 0.62%.
When the Chancellor announced the budget, the yield curve flattened (see jargon buster below for definition). He announced the Office of Budget Responsibilities (OBR) latest forecasts for the UK economy showing growth of 6.5% in 2021 and 6% in 2022. With high growth and inflation expected to top 4% at the end of this year, the BoE may find it hard not to respond by raising interest rates soon. However, given the OBR growth forecast for economic growth to slow to 4% in 2023 and to only 1.3% in 2024, the need to intervene heavily is less clear. While Sunak increased spending in many areas, tax is also rising which may hamper growth in the future. There have been recent comments regarding ‘a high tax, high spending Chancellor, more like Gordon Brown than George Osborne’. This combined with the recovery has put public finances in better shape resulting in less than expected issuance of gilts. While the market has priced in several rate rises from the BoE in the next year, we are yet to see the impact of the end of the furlough scheme, which may give them reason enough to delay acting when they meet next week.
The 30-year gilt yield has fallen from 1.37% to 1.15% in October at the time of writing, equating to a price rise of 6%, which is not a bad return for a bond when interest rates are expected to rise. Many people assume you cannot make money in bonds when rates rise however this demonstrates that is not always the case. Some have gone as far as to suggest that in the present environment bonds are un-investible, we beg to differ preferring to take a subtle approach to managing bonds.
In the US, the yield curve also flattened ahead of the Federal Reserve (Fed) meeting next week. The Fed are widely expected to taper their bond buying programme either at this meeting or the next one in December. We will watch closely for their actions and the wording around any move. So far, the Fed have indicated that they want to taper first and have set a higher bar for an actual rate increase. This would imply that a rate rise will not come until the second half of next year at the earliest. The European Central Bank (ECB) met this week, and at the press conference, President, Christine Lagarde, hit back hard at market expectation which already moved to price in a rate rise for next year. She was firmly of the belief that inflation in Europe was transitory and if they were going to maintain 2% inflation in the long-term policy needed to remain accommodative, however the emergency bond purchase program remains on track to end in March 2022.
The yield curve is a fair predictor of the direction of rate moves, but in almost every cycle predicts more rate rises than actually materialise. When inflation is high those that have been talking about high inflation for many years speak loudest. Likewise, those that have been permanently bearish will get attention when markets are down. This tendency only encourages more pronounced market moves. When looking at bonds, rising official rates are not as important if they are expected. If the market thinks that rates are going to rise too fast, paired with less fiscal largesse, then they may see the risk of economic growth slowing further out and may move to price lower rates in the long run. This appears to be what has happened during October.
When investing in bonds careful positioning along the curve is important. Long dated bonds have proven to be a good hedge for equities when the economy slows and may still be even when interest rates are low, For now we prefer US bond exposure to balance portfolios where interest rates are higher than the UK or Europe. In the past, private client portfolios tended to trade equity and hold bonds to maturity. Today, I suggest that holding firm with equities through volatile times is sensible, however, with bond exposure a more nimble and nuanced approach is recommended. Despite low interest and the prospect of higher official rates there are opportunities and they continue to have a place in balanced portfolios.
Those familiar with the yield curve can skip this paragraph. We try and avoid the use of technical language in these weekly notes but occasionally some explanation is needed. If you plot bond yields on a vertical axis and maturity on the horizontal axis you can plot a yield curve line that shows how interest rates change with different maturities. This is normally upward sloping, or a positive curve, as investors get a higher yield for lending to governments for longer. If it is positive at the short end it may also indicate that interest rates are expected to rise. If it is downward sloping, or negative, it indicates that interest rates are likely to fall.
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