I is for Interest Rates

There’s something valuable in every letter of our investing alphabet. But it’s hard to think of one thing that impacts the investment world more than today’s topic. I is for interest rates.

In today’s world our central banks like the Bank of England in the UK and the Federal Reserve in America seek to control the economy and the markets with ever more intervention. Since the two thousand and eight financial crisis we’ve tended to hear more about money supply and quantitative easing. But the main lever they use to implement monetary policy has always been interest rates.

The Bank of England sets the base rate, which is the rate at which the commercial banks like Barclays and Nat West borrow from the central bank. They have a monetary policy committee which meets every month to decide what the base rate should be. In times of economic stress they have tended to lower rates to get the economy moving, then raise them as things take off so as not to let inflation run riot. However, things have been far from normal this time round. In response to the crisis rates were brought down to a four hundred year low of nought point five per cent in two thousand and eight. We were told this was an emergency rate to help us recover from the credit crunch. Err, here we are seven years later and the emergency rate is still in place.

Money Week’s Tim Price is unequivocal on this – he calls it financial repression. If you’re a saver or a retiree who had to buy an annuity in the last decade, I feel your pain. The other impact of artificially low interest rates has been bubbles in other assets from property to classic cars, from art to autographs. When money is virtually free people will grab as much of it as they can and put it into assets that they believe will give a better return than cash. The bellwether for global interest rates is Americas Fed, headed up by Janet Yellen. Every statement she makes is analysed for any hint that rates may finally be on the move. Remember what we learned about bonds, a market that dwarfs the stock exchange? If interest rates go up, bond prices come down.

Much of your pension will be invested in bonds, especially if you’re north of fifty. While you have learned to expect volatility in the stock market, there’s been a thirty year bull market in bonds as interest rates have steadily declined from their peak in the nineteen eighties. Your financial adviser probably tells you that bonds are safer than those risky stocks and shares. Ignore him. This is no time to be heavily exposed to bonds. Interest rates can only go one way in the medium term.

Deflation already looks to be over after the spike back in oil prices. If you are or aspire to be a serious investor you need to keep an eye on interest rates their future direction. One of the best predictors of this is the yield on US treasury bonds and UK gilts. The yield on ten-year UK gilts has risen from one point six per cent to two per cent in two months. Ten year US treasuries have gone from a yield of one point six eight per cent in February to two point four nine per cent in June. That’s a forty eight per cent swing in four months. And they call these safe assets as you approach retirement!

All the signs are that rates will finally start rising in the first half of twenty sixteen. Everyone seems to think they’ll drift up to around two per cent by twenty seventeen and that a new normal will be established closer to three per cent than the historic five per cent. Let’s wait and see. The market has a habit of making fools of those who seek to predict what she’ll do next. But don’t get blind sided. Watch those key gilt and treasury rates and be on the right side of the moves when they inevitably happen in the not too distant future.