Market Updates

Today’s decision by the Bank of England’s Monetary Policy Committee to raise the benchmark interest rate by 0.25 percentage points has had little immediate impact as the decision was widely anticipated. The probability of an interest rate hike had moved to 90 per cent over the summer.

Bond markets had been waiting patiently for this move ever since May, when the Bank of England was poised to raise interest rates but decided to hold off at the last moment after a slew of disappointing data. During an April interview with the BBC, Carney reset the expectations for gilt investors, as he was “conscious that there are other meetings over the course of this year.”

Portfolio Manager’s View
Early signs are positive for the FE Invest model portfolios, as Gilts have actually rallied on the news. With the rate hike itself already priced in, much of the focus has been on the bank’s long-term expectations, which matter more to long term bonds than the short-term rate hike.

As has been the pattern here and in the US with previous hikes, the move has been accompanied by a deterioration in the long-term outlook, with analysts becoming more negative on future growth based on today’s move. It is a phenomenon called yield curve flattening and has had a positive effect on the gilt funds in the portfolios. The sentiment has also weakened sterling which will boost the portfolios’ international holdings as well.

Analyst’s View
Recent economic data suggests that the UK economy is still expanding (albeit at a slower pace) and that inflation probably peaked in the first quarter of 2018, as the UK economy has recovered from the first quarter blip. This has proved to be enough to justify this interest rate hike and bond investors will now get more clarity about the future path of interest rates.

Prior to this announcement, expectations of the second rate hike since 2007 has created volatility over the short end of the curve but had barely affected the long part. There is little in recent data that would warrant significant revisions to the BoE’s UK long term growth forecasts (at least beyond the end of the Brexit negotiation). Mr Carney has made it clear that the BoE does not intend to start publishing official forecasts on the future trajectory of rates. However, as suspected it has published, for the first time, its estimate of the “neutral rate of interest”, the rate at which the central bank believes the UK could grow at a sustainable rate with the economy at full employment. In the inflation report, they have confirmed that “any rises in Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come”.

With little sign of improved economic growth or sudden rise of inflation, gilt investors may make the case that yields won’t rise much from their current levels despite today’s interest rate rise. With still little clarity around the Brexit negotiation and possible economic disappointments to come, we believe it would be premature to completely disinvest from this asset class.
Author: FE Analytics