David Roberts

Time to dust off the old textbooks for when interest rates go up

David Roberts

There were few market commentaries that accurately predicted how the US Federal Reserve and Bank of England would react to the current growth and inflation debacle. Hardly any that I read spotted the resultant hawkish tone, nor the bearish bond market reaction.


The question is why the change of tone now? We’ve had a QE (quantitative easing) decade and 18 months of pandemic misery during which we have been constantly dismayed by the underestimation of the disruptive impact of massive monetary and fiscal stimuli. Central banks failed to spot inflation – which has averaged 4% in the US since March while 4%+ is likely to be seen in the UK and Germany later this year.


Central banks failed to spot the economic imbalances that unfettered free money inevitably brings: Evergrande and the UK natural gas debacle are just the latest examples. They failed to understand the impact of price rises on rampant nominal growth. And let’s be honest, the “it’s all about jobs” argument just doesn’t wash with over 10 million vacancies in the US and a record 1.2 million in the UK, and yet unemployment remains around 5% in each country.


Comments from the Federal Open Market Committee (FOMC) and BoE’s Monetary Policy Committee (MPC) suggest a quicker reduction in free money than many had thought. The Fed was up first. An initial reading of its statement suggested to many a modestly more hawkish tone but one that could be ignored by investors. However, events later that week proved catalysts for bond market sell-offs and renewed talk of “reflation”.


Two members of the MPC wanted to end QE. The accompanying rhetoric talked of high inflation and a risk of it going higher still. Around the same time, the Norges Bank raised interest rates – yes, that can happen!


Taken together, these actions seemed to cause a reappraisal of the Fed’s position. Bond markets had one of their worst days for years. UK 10 year gilt yields threatened to move to 1% (still 3% below the MPC short-term inflation forecast). We haven’t seen this level for around two and a half years.


Arguably central banks should have been reducing stimulus for the past year ahead of the inflation spike. Perhaps the level of economic imbalance is now just too great to ignore? For example, the MPC noted the economic threat from higher UK gas prices. In the past, they would have ignored this and not responded to “idiosyncratic” events. The problem is that when adding all the idiosyncratic events together, it starts to look systemic.


Market rates have risen but in truth just a little and only to levels that should still favour borrowers. However, signs are that several other central banks will follow the Norwegians and raise rates in the coming months. Maybe it’s time to dust off those old investment textbooks and read how to invest when interest rates go up?


How have we positioned the Liontrust Strategic and GF Strategic Bond funds for this environment? The funds’ duration currently stands at around 2.5 years, which is well below our longer-term “neutral” duration of 4.5 years. We think there is no value for long-term investors by simply buying bond beta and therefore we are focusing on alpha opportunities.


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Monday, September 27, 2021, 11:04 AM