Central bankers sprung no surprises last week. The US Federal Reserve (Fed) left rates unchanged, maintaining their 5-5.25% range. The consensus amongst economists is that this is a skip rather than a halt.
Indeed, the Fed is projecting more hikes, consistent with two further 25bps increases. Backing this up, their economic forecasts were revised higher and expected unemployment lowered. Consistent with these moves, the core inflation forecast has been revised higher and is now expected to be at 2.25% in 2025. But investors are not so convinced that further rate increases are likely. Looking at what is priced in shows scepticism that the Fed will deliver these hikes.
There was less ambiguity from the European Central Bank (ECB) and no sign of a pause. The 25bps rate increase took the deposit rate to 3.50%. The clear message was that whilst inflation is coming down it is projected to remain too high for too long. And the revisions to forecasts did not match the Fed’s. An upward revision to core inflation sat alongside a downward revision to growth. It is tightness in labour markets that is the ECB’s chief concern and two more 25bps are on the cards.
The market with the biggest recent change in interest rate expectations is still awaiting its central bank’s decision. The choice for the Bank of England (BoE) is a hike of 25bps or 50bps – unchanged is not a realistic option. Two years ago, we were talking about the possibility of negative rates; today pricing indicates a Base Rate of 5.75% by Q1 2024 (from 4.50% today). Two-year rates are above the level seen during the mini budget sell-off and 10-year yields at 4.4% are not far off. However, long yields are still someway back from the September 2022 levels and the tone of the market is different. The forced selling seen from Liability Driven Investing managers is not occurring and there is a gentler re-pricing underway.
Confession time. I did not see these sort of rates being priced into markets – but I believe it is a great opportunity. Regular readers of this blog know that I have turned positive on UK government bonds and advocate extending duration. This is not, however, to diminish the attractions of short-dated bonds. For investors whose focus is less on matching pension liabilities and more on opportunities at shorter maturities, I think that present valuations look outstanding. Across the short-dated spectrum, from money markets to short dated high yield – I am struck by the attractive yields available. These yield levels have not been seen in years – dating back to before the Great Financial Crisis. Cash and short-dated bond strategies do not have the same potential for capital appreciation that could arise from a fall in interest rate expectations. But this is just another way of saying they are less volatile, less upside and less downside. With yields where they are and pricing in a significant further tightening of monetary policy, I think short maturity bonds will appeal to investors that have been on the side lines.
There is a lot of attention at the moment on the UK housing market and the potential impact of higher mortgage rates. Indeed, there has been some speculation that directed government support may be forthcoming to ease the burden. What successive governments have failed to realise is that tinkering in the UK housing is not a sound long-term strategy. In effect, it is counterproductive, inflating the cost of a first time buy. House prices need to adjust to the new interest rate environment – just like bond prices have.
Bonds markets were mixed last week. US treasury yields were broadly unchanged with the 10-year at 3.75%. Other markets saw an increase in yields; German 10-year yields approaching 2.5% and the UK equivalent finishing above 4.4%. Credit spreads remained unchanged and towards the lower end of recent ranges. A big beneficiary of the change in interest rate expectations has been sterling, which ended the week above 1.28 against the US dollar. This should help ease some inflationary pressures but not enough to stay the hand of the Bank of England on Thursday. Expect more headlines about mortgage costs.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.