Interest rates look set to stay at record lows until 2016 following guidance in the Bank of England’s latest inflation report. However, new Bank Governor Mark Carney added three “knockout” caveats that could trigger an earlier rate rise, although their credibility is in question. In the meantime, UK savers’ tough challenge to generate a real return on their cash savings continues, says Alan Higgins (pictured), Chief Investment Officer, UK at Coutts…
Rate rise linked to unemployment
In its latest inflation report, the Monetary Policy Committee (MPC) said that it does not intend to raise the Bank Rate from its current 0.5% until the unemployment rate has fallen to 7% – it currently stands at 7.8%. The caveat to this ‘forward guidance’ is that keeping rates low doesn’t risk the Bank of England’s (BoE) primary objective of maintaining price and financial stability.
Unemployment falling from 7.8% to 7% is equivalent to adding around 750,000 new jobs, which the BoE doesn’t expect to be reached until at least the third quarter of 2016. However, speaking at a press conference, the Bank’s Governor, Mark Carney – who admitted that it is “an exceptionally challenging environment in which to set monetary policy” – emphasised that the 7% threshold will not be an automatic trigger to raise rates. He added that there is “no presumption that breaching any of these knockouts would lead to an immediate increase in the Bank Rate or sale of assets [quantitative easing]”.
On inflation, Carney said that it is “more likely than not” that Consumer Price Index (CPI) inflation will be 0.5 percentage points or more above the BoE’s 2% target in 18 to 24 months’ time.
Our reaction
Carney’s confirmation that UK rates will stay low for longer suggests investors and businesses can invest with confidence in the short term and homeowners with mortgages linked to the Bank Rate will not face imminent increases to their monthly payments. UK two-year fixed mortgage deals are already at record lows and this should give greater confidence to banks to launch more of these products.
The BoE’s three “knockouts”, two of which are related to maintaining price stability and the third concerning financial stability, still leave open the possibility of a rate rise before 2016. However, we believe the caveats are weak (they are subject to the Bank’s own forecasting rather than an independent body and not clearly defined; for example, it’s far from clear what would constitute a breach of “financial stability”) and undermine the new strategy. They may have been included to appease certain MPC members.
Even if inflation remains benign as predicted, and the knockouts are not triggered, the day of reckoning will come when rates rise. However, we believe the BoE will not choose to raise rates until there is a positive wealth effect, such as from significantly higher stock markets.
What does this mean for sterling?
The guidance reinforces our view that sterling is likely to weaken moderately against the dollar over the medium term. Carney is committed to keeping policy highly accommodative for as far as the eye can see. Meanwhile, although the timing of an initial move remains uncertain, the US Federal Reserve remains on track to start a gradual withdrawal of policy support sometime over the next year.
As this contrast in policies evolves, we expect the sterling/dollar exchange rate (dollars per pound sterling) to move back to levels around the lower end of its recent trading range of 1.48-1.54. With eurozone policy also likely to remain highly accommodative for the foreseeable future, we continue to expect the euro/sterling exchange rate to remain close to current levels (0.86).
What does this mean for savers?
With interest rates likely to remain below inflation for the foreseeable future, cash will generally continue to offer negative real (inflation-adjusted) returns. Modest inflation might not seem to pose much of a threat to cash investors, but it will erode the value of wealth when combined with low interest rates.
If inflation were to run at the Bank of England’s target of 2%, GBP100,000 would be eroded to GBP66,671 in real terms 20 years later. At 4%, the real value would drop to GBP44,200, while at 5%, the original GBP100,000 would be worth just GBP35,849 after 20 years.
And that’s just part of the story. Official inflation figures, such as the CPI, don’t accurately reflect many people’s lifestyles. For example, the costs of school fees, property and private healthcare have been rising at considerably faster rates than official inflation.
What are the alternatives to deposits?
For risk-averse investors, products such as customised deposits and structured investments can offer more attractive returns than those available on deposits. Customised deposits pay an interest rate linked to the performance of an underlying asset, such as equities, currencies or commodities. They typically have terms up to five years and provide capital protection if held to maturity – although they are subject to the risk that the deposit taker might be unable to repay at the end of the term.
Structured investments are generally pre-packaged investments that rise or fall with the performance of various asset classes or markets, and which can have full, partial or no capital protection.
What does this mean for investors?
Carney’s expectation that the UK economy will continue to improve will boost the prospects of certain sectors of the equity market. The ‘low for long’ view on rates will help homeowners and potential homeowners, with this improvement to housing in turn boosting the wealth effect and encouraging consumerism. In this way, the house builder and consumer-discretionary sectors should benefit from the new policy.
Risk-averse investors looking for income have historically turned to fixed-income markets. But with yields on government bonds having fallen to record lows below the rate of inflation, quality sovereign bonds don’t hold the answer to wealth preservation.
Investment-grade corporate bonds are underpinned by strong corporate balance sheets and a benign default outlook, but low yields and higher duration (sensitivity to interest rates) will keep absolute returns modest. Meanwhile, income from high-yield corporate bonds has offset falling prices so far this year and yields now better compensate for higher volatility and a potentially weaker near-term economic outlook.
For investors willing to take on more risk, high-yielding shares offer respite from low interest rates. While we don’t see any sudden shift away from defensive stocks, where higher-dividend-paying equities tend to be concentrated, we think some areas have become expensive. As a result, we have adopted a YARP (yield at a reasonable price) approach that favours cyclical stocks – here we see good and growing dividends from materials, financials and some technology companies.
