Last week saw a surprise fall in inflation data and the Bank of England deciding not to hike rates, with its chief economist describing a Table Mountain plateau in rates rather than a sharp ascent to (and descent from) a Matterhorn peak. Should investors be excited about a turning point in the battle against inflation?
The annual rate of UK inflation moderated to 6.7% in August, down from 6.8% in July and significantly better than economists’ forecasts of an acceleration to 7.0%. Core inflation, which excludes food, energy, alcohol and tobacco, was down even more markedly, from 6.9% to 6.2%.
Financial markets reacted swiftly to this surprise, with key moves including housebuilder share prices jumping as expectations of Bank of England base rates fell. Derivatives markets had previously been pricing an 80% chance of the Bank of England pushing through its 15th successive base rate increase to 5.5%. This dropped to 50% in the wake of the inflation data.
Phil Milburn, co-head of the Global Fixed Income team saw the data as good news for investors: “Overall, I would characterise this undershoot of inflation relative to expectations as being a very positive development. The only negative points are that the absolute rate of inflation is still far too high, and a couple of volatile items in the core services measure have flattered the figures.
However, the breadth of the deceleration in inflation is increasing, so even if volatile items do rebound in upcoming months the broader downward trend should remain intact.”
The following day the Bank of England (BoE) chose to break its run of hikes by holding rates steady at 5.25%. It was a close vote with the Bank’s rate-setting committee being split 5-4, with the dissenters all preferring a 25bps hike.
In explaining its decision the committee said "...the decision on whether to increase or to maintain bank rate at this meeting had become more finely balanced between the risks of not tightening policy enough when underlying inflationary pressures could still prove persistent, and not placing sufficient weight on the impact of the previous tightening that was still to come through on activity and inflation.”
The potential for a lagged policy impact is something the Sustainable Future fixed income team has been factoring into its portfolio positioning: “What has surprised many investors this year is how robust the underlying economy has been despite the monetary policy tightening over the last year or two. One potential reason for this is that changes to central bank base interest rates typically affect the economy in a lagged manner.
For example, according to the BoE, the proportion of fixed-rate mortgages has increased from around 30% in 2010 to around 85% presently. Homeowners on fixed-rate mortgages will have been protected against the impact of higher rates, but this will change as they refinance their fixed deals over the coming months and years.”
The Sustainable Future fixed income team expect total returns from the asset class to be strong over the next 12-18 months. They have positioned their portfolios to be long duration – a measure of interest rate sensitivity – meaning they should benefit if they are correct in their view that yields will fall.
Their base case on a 12-month view includes 10-year gilts returning to a yield of 3.25% and corporate credit spreads tightening by 25bps on a 12 month view.
Milburn has also positioned the Global Fixed Income team’s portfolios to be long duration, taking on about twice the benchmark’s level of rate sensitivity (having for many years been well below it due to unattractively low bond yields). However, Milburn now sees increasing value outside of the UK:
“There has been recent outperformance from UK government bonds versus the US equivalent, to the point that the 10-year UK bond now yields less than the US.
The UK does have lower economic growth, but it also has higher inflation as well as some risk premium needed for the institutional instability we have seen over the last few years of political chaos. So we have reallocated some UK exposure towards US and German government bonds. We still retain around a quarter of our duration exposure in the UK though.”
While the decision to hold rates steady has been seen as the headline event in the Bank’s announcement, Milburn finds some cause for consternation further down the statement.
Having enacted a massive bond-buying programme (quantitative easing) in the aftermath of the global financial crisis in order to keep borrowing rates low and stimulate the economy, the Bank is now unwinding this by selling these bonds back (quantitative tightening). The Bank announced last week that it will increase rate at which it reduces its bond holdings from £80 billion a year to £100 billion. While around half of the £100 billion reduction will be achieved by simply allowing bonds to redeem at the end of their life, the other half will be sales. The problem is, most of these bonds sit at losses compared with when the Bank purchased them due to the sharp increase in yields over the last 18 months.
Milburn explains his frustration with the scheme: “I have been quite vocal about how the Bank of England was slow to react to the inflationary problem, such that an initial supply side shock to prices broadened out to be a much more endemic phenomenon. This has led to interest rates having to be raised much higher than they would have otherwise been if the Bank of England had reacted sooner. However, this is nothing compared to my frustration with the probable losses that will arise from the unwind of quantitative easing (QE).”
“While the Bank’s bond-buying initially led to paper profits for the government, which ultimately underwrote the scheme, it is now leading to significant loses for the public purse. Bank of England data shows that, using market yields at the end of June, the total loss is currently on track for £150bn
I don’t think the losses will turn out to be quite as large, as I expect the Bank to cut rates next year by more than factored into these estimates. But the losses will still be eye-wateringly large”
While bond investors will be encouraged that inflation appears to now be heading in the right direction, it still remains very high in absolute terms and there is a long road ahead to the Bank’s 2% inflation target. It seems that the regular scrutiny of inflation data and Bank of England statements will continue for some time yet.
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