Where UK interest rates are going, and why
30 November 2017 | Markets and Economy
Alexis Gray, economist, Vanguard Europe.
In November, the Bank of England raised interest rates for the first time since 2007. We have spoken with many investors in recent years who are worried about the prospect of rising rates. The key concerns are that sharply higher rates may lead to bond portfolio losses or difficulties making mortgage payments.
These are legitimate concerns. Many investors can still remember the 1994 bond market crisis when interest rates in the United States rose by 3% in just over a year, causing a global bond portfolio (hedged in sterling) to fall 4.8% in five months1.
Are we likely to see a similar crisis in the United Kingdom in 2018?
At this point it appears unlikely that interest rates will rise quickly in the UK given the absence of strong economic performance or inflation pressures (setting aside the temporary inflation spike which came after the depreciation of sterling). Nevertheless, as an investor, it is sensible to plan for different scenarios by remaining broadly diversified and by understanding how higher rates may affect your investments.
So where to from here for interest rates?
In the commentary following the rate decision, the BoE suggested that any further rate increases are likely to be "gradual" and "limited". This implies that the Bank does not intend to raise interest rates rapidly or to lift them back to pre-crisis levels. It is of course possible that we have a positive surprise to growth or inflation, leading to a faster pick up in rates, but this is not our central forecast at Vanguard at the moment.
The Brexit factor
The wild card for the UK economic outlook is Brexit. There is a lack of clarity around which type of Brexit deal may be done – whether it’s a soft or hard Brexit, or perhaps no deal at all. Moreover, there is instability within the Tory government and the possibility of a leadership contest. All of this uncertainty make it a challenging task for the BoE to set interest rates over coming years.
In the short term, progress on Brexit negotiations may have a heavy influence on rate decisions. If for example, the UK government fails to map out a clear path forward beyond the March 2019 European Union exit date, such as the agreement of a multiyear transition period, then businesses may scale back investment and hiring plans. Indeed, there have been numerous comments from big business in the press over recent weeks that clarity is urgently needed. If Brexit uncertainty persists, the Bank of England may leave rates on hold throughout 2018. If on the other hand there is a breakthrough in negotiations relatively soon, rates may rise one or two times in 2018.
Looking further ahead, even if a transition deal can be reached by early 2018, the transition to a hard Brexit would likely represent a negative shock to the economy as the UK loses its current favourable trading relationship with the EU, and as European migration to the UK slows down or even reverses. As such, any tightening in monetary conditions associated with a more orderly Brexit would still be relatively measured. So the BoE would resume raising rates, perhaps with another one to two interest rate hikes by year-end 2018.
What should you do?
Although rates are likely to rise further in coming years, we do not expect the rise to be sharp or to reach the levels realised before the crisis. This means that substantial portfolio losses are unlikely for investment grade bonds.
It is true that as rates rise this represents a fall in bond values, and hence a short term capital loss. However, over time higher rates mean investors’ holdings will earn a higher yield, leading to higher returns. Investors who reinvest these distributions will be able to reinvest them at higher yields, allowing investors to benefit from the virtuous cycle of compounding interest at a higher rate. In effect, rising rates mean short term pain, but long term gain.
For more risky asset classes such as property or equities, the impact of rising rates is unclear, as historically there has been no consistent relationship between interest rates and the prices of such assets.
None of us has a crystal ball so unfortunately we do not know exactly what is lying around the corner. What we do know is that holding a broadly diversified portfolio across asset classes, sectors and regions is one of the best ways to protect against this uncertainty.
1 Global bonds represented by the Bloomberg Barclays Global Aggregate Total Return Index.
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