A cut above
The Bank of England chose to leave rates on hold this month, but a dovish new phase is expected, with implications for fixed income – and for cash.
One of the strange habits of stock markets in recent weeks has been their tendency to rise, after a brief initial dip, in the wake of what is widely perceived as negative economic news, from disappointing growth figures to the UK’s vote to leave the European Union.
Yet there is an important logic at play, albeit one that may only make sense in the short term. Given the fragility of global growth, markets expect central banks to take supportive action whenever key indicators begin to flash red or major events pose a threat to growth. That support either comes in the form of lower interest rates, which are designed to increase business and household spending, or in the form of quantitative easing, which buoys asset prices.
Markets had therefore been looking forward to the July meeting of the Bank of England (BoE), as they expected Mark Carney to announce a drop in interest rates – perhaps even an asset-purchase programme. This expectation had been based on comments he had made following the referendum result declaration, in which he stipulated that the Bank would need to act over the summer to deal with deteriorating confidence. When the Bank then voted 8–1 to leave rates on hold, Carney was once again described in the comments of a handful of economists and newspaper columnists as an ‘unreliable boyfriend’, a charge first levelled at him by a Labour MP in 20141.
“Market consensus was for a 25bp cut in the UK base rate [at the July meeting], hence we saw some reasonably large [immediate] moves in the underlying price of gilts [i.e. UK sovereign bonds] and short-term gilts, as professional traders and investors re-evaluated positions,” said Gary Kirk of TwentyFour Asset Management.
Of course, interest rates were already at historic lows and the Monetary Policy Committee (MPC) may have wanted to hold onto what little firepower remains in its arsenal. Besides, a rapid rate drop might have only stoked the anxiety already felt on markets following the referendum.
“The [referendum] result announcement on 24 June was only three weeks before and the Bank of England quite rightly [felt the] need to see more economic data to see the real impact of the decision to leave the EU and to justify any change in policy,” says Kirk.
Credit where credit’s due
Credit spreads have remained tight in recent weeks, meaning that fixed income has been popular with investors – prices have risen. Sovereign bonds in some developed markets have been so popular that their yields have turned negative, notably in Germany. When sovereign yields fall, corporate yields tend to follow, albeit at a distance.
“In terms of credit, the market has been well supported,” says Kirk. “Going into the referendum, the market was awash with cash… with rates staying artificially low and default rates expected to remain low, there has been a demand for yield product that has outstripped supply and hence credit spreads have tightened.”
The popularity of bonds reflects the fact that, despite significant inflows, plenty of good opportunities remain for investors with a global fixed-income perspective. Moreover, in the case of the UK, those inflows may well prove sustained.
“[Due to high expectations of an MPC rate cut in August,] the market appears to remain committed to gilts and the demand for credit product is strongly expected to continue over the summer,” says Kirk.
There is another important lesson for investors to draw from the current rates–bonds nexus, however. Just this week, RBS announced it would start offering negative rates to business customers – its decision may yet prove to be merely the first. But by keeping cash in any bank, you may be accepting almost zero interest, especially once inflation is factored in – and it could be technically zero before the year is out, if rates drop further. Moreover, if BoE rates fall still further, then cash becomes vulnerable to the inflation hike now expected as a result of the drop in sterling.
In the Monetary Policy Summary released on the day its rate decision was announced, the BoE said that financial markets had reacted strongly to Britain’s decision to leave the EU, but that its decisions were dependent on official data, which had not yet materialised for the period since the referendum.
Looking back at the past fortnight, however, the Bank could point to limp June tax revenues data, and to business sentiment reports published by Markit and the CBI as evidence that there had been a material downgrade to the outlook. Markets continue to price in a very high probability of an August rate cut – they seem to trust that Carney is a reliable boyfriend, after all.
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The opinions expressed are those of TwentyFour Asset Management and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.
TwentyFour Asset Management is a fund manager for St. James’s Place.
1Among those to resurrect the term was Alan Clarke, chief economist at Scotiabank: http://www.mortgageintroducer.com/mark-carney-return-unreliable-boyfriend/