Where next for interest rates in the US, Europe and UK?

Olly Russ, Phil Milburn, David Roberts, Jamie Clark and Stuart Steven

Where next for interest rates in the US, Europe and UK


Following a decade of ultra-loose, extraordinary levels of monetary policy – near zero interest rates and massive money-printing quantitative easing programmes – many had expected 2019 to be the year when the tide turned.


This has not turned out to be the case in the first quarter as key central banks have softened their rhetoric on future interest rate rise. This shift in tone was encapsulated in the US Federal Reserve’s recent adoption of a “patient” approach to rate rises. Having enacted nine quarter-point rate rises over two years, the Fed had in December 2018 forecast that it would implement another two hikes during 2019. However, it has since completely backed away from this, and now expects to leave rates on hold at 2.5%. It even plans to halt the very slow unwinding of quantitative easing which it began in the second half of 2018.


European policy rates remain at their lows of between -0.40% and 0.25%, while the Bank of England rate of 0.75% is only half a percentage point above the 0.25% low to which it was cut in the aftermath of the shock EU Referendum result.


With the direction of interest rates looking very much up in the air, we asked some of our fund managers what we should expect from US, European and UK central banks this year.

 


 

Where next for interest rates in the US, Europe and UK


US Federal Reserve:

we expect talk of the Fed being ‘behind the curve’, with rate hikes to follow in the second half of the year.”

Olly Russ, European Income team: The US Federal Reserve does appear to be “data dependent”, as it has often claimed. However, this data appears to consist mainly of the current level of the S&P500!

The Fed Put – the modern spin on the 1990s Greenspan Put – is a theory that the central bank will always be willing to act as a safety net to financial markets, cutting rates to provide stimulus if market levels fall.

Following the tumble taken by global equity markets towards the end of 2018, this is in effect what we saw from the Fed: it backed away from plans to raise rates twice this year, and instead expects them to remain on hold. Investors are now hopeful that a cut might even be possible this year, and have priced this into rate futures.

This dovish move has allowed markets to rebound. If they stay strong, we expect talk of the Fed being ‘behind the curve’, with rate hikes to follow in the second half of the year.

Phil Milburn, Global Fixed Income team: The current reliance on the central banking “put” is not prudent and rising inflationary pressures should lead to a second Federal Reserve U-turn later in the year.  

The economic growth scare over the last few months has gone too far. This means talk about the likelihood of central bank loosening, as opposed to tightening, has also been overdone. We anticipate that ongoing strength in consumer spending and the services sector will overcome the current malaise in manufacturing.

If we see some positive resolution on Brexit and trade, then I think US rates should rise later this year. Whether they will, however, is less certain and is where the Fed may be entering dangerous territory.

The Fed being so dovish is a dangerous thing for the longer term and risks higher inflation becoming embedded within the US economy. If the Fed were then forced to belatedly act to curb excess and tighten too much, then we could hit recession.

Where next for interest rates in the US, Europe and UK

European Central Bank


Core economic concepts such as the Taylor Rule and Philips Curve suggest that current ECB policy is inappropriate”

David Roberts, Global Fixed Income team:  Government bonds are ridiculously expensive in absolute terms and even more so when adjusted for inflation. German bunds illustrate this point well: the 10 year recently moved into negative territory for only the second time in history. By our calculations, German bonds are as expensive as they’ve ever been in the past century. Fundamental economics would need to collapse to justify them.

Core economic concepts such as the Taylor Rule and Philips Curve suggest that current ECB policy is inappropriate.  Although the European economy isn’t exactly powering along, growth and inflation, are firmly in positive territory. Indeed there is a better balance to growth than for some time, with the long-term engine of German manufacturing actually being the weak spot.

Olly Russ: While euro zone exports have taken a downturn, particularly the auto sector due to US-China tariffs, domestic demand is holding up well. If exports turn around in the second half of the year, then the ECB might be enticed to consider policy tightening again.

One piece of data that could prove interesting is euro zone supercore inflation – a gauge of underlying inflationary pressures. This shows a distinct upward trend, currently running at 1.3% (February 2019) up from 1.1% last year and 0.9% two years ago

Where next for interest rates in the US, Europe and UK

Bank of England


“Once a Brexit resolution has been achieved we expect UK rates to be unshackled.”

 

Jamie Clark, Macro-Thematic team: We believe that interest rates will rise as the scars of the Global Financial Crisis fade. This is a view we’ve reflected in portfolios through a thematic tilt to companies we view as beneficiaries of rising rates.

The last decade of low rates and disinflation will come to be seen as a temporary feature of the economic landscape and not a new equilibrium. This outlook is contrary to the view of many: UK interest rate futures currently imply only a one in five chance of rates increasing to 1.0% by this time next year.

 

While the UK may not be booming, the economy has surpassed the gloomiest of forecasts. This is most apparent from the strength of the UK labour market. At 3.9% the unemployment rate is as low as it’s been since Status Quo’s ‘Down Down’ was number one in Q1 1975. The resultant labour market tightness explains why UK wage growth is running at 3.5% annualised; a pick-up on 2017’s 2.3% and 2009-2016’s modest 1.6%.

 

Once a Brexit resolution has been achieved we expect UK rates to be unshackled.

 

Longer-term, the exhaustion of monetary policy options in the last decade may lead to a renaissance of fiscal ‘demand side’ stimulus, i.e. government spending. This in itself has an inflationary impact and would put upwards pressure on interest rates. Furthermore, long-term demographic trends are also inflationary. As the UK population ages, this implies more dependents and fewer workers. In turn, this suggests less disinflationary saving and more inflationary consumption.

 

Stuart Steven, Sustainable Investment Fixed Income team: We believe the Bank of England is keen to raise rates in the event of an orderly Brexit. We have expressed this view through a one year underweight duration position to UK government bonds. An orderly Brexit is the most probable outcome in our view, with recent developments reducing the likelihood of a ‘no-deal’ exit.


For a comprehensive list of common financial words and terms, see our glossary here.

 

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Tuesday, April 23, 2019, 9:51 AM