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What Next For UK Interest Rates?

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Summary

What does an interest rate rise mean for the economy and Coutts portfolios and funds?

3 min read

Almost everyone seems to agree that The Bank of England will announce the first UK interest rate rise in a decade tomorrow, but in our view the bigger question concerns its longer-term plans.

The Bank of England’s (BoE) Monetary Policy Committee (MPC) is facing a classic ‘Hobson’s choice’ on interest rates. Higher than expected GDP growth and inflation last month, tight labour market conditions and months of coy hints from central bankers have made a rise tomorrow a near certainty.

At Coutts we think the BoE will raise rates to 0.5% from the current 0.25%, reversing the emergency rate cut it introduced following 2016’s European Union referendum result.

If the BoE flinches and fails to raise rates this time it could tarnish the bank’s credibility, and governor Mark Carney will certainly want to avoid reinforcing his “unreliable boyfriend” reputation. In addition, if they don’t hike now, they may have missed their opportunity to normalise interest rates as Brexit clouds gather over the economy next year.

“At Coutts we think the BoE will raise rates to 0.5% from the current 0.25%, reversing the emergency rate cut it introduced following 2016’s European Union referendum result.”

No alarms and no surprises, please

With markets primed for a rise, a hike should see business as usual for markets.

We believe there is still scope for sterling to strengthen slightly, but not much as the effects are largely priced in. Following its dramatic post-EU referendum drop, we see sterling eventually returning to something closer to historic levels against other currencies. We have therefore aligned our portfolios and funds accordingly.

A rate rise is also likely to add to the weakness we’ve seen in gilts since the summer. We have held a low allocation to gilts for some time having seen them as poor value and, where we continue to hold them, we have already shortened the duration in anticipation of rate hikes. This helps insulate our portfolios and funds from the consequences of rising rates generally.

Diversification remains a core investment principle at Coutts and our preference for alternatives such as commercial property and market neutral strategies over traditional gilts has also been beneficial so far this year.

 

The road not taken?

The decision on what to do with interest rates does not rest with any one person. Nine people sit on the MPC and the vote is likely to be close. Indeed, there is a chance it could go the other way.

Although this isn’t expected, the BoE is no doubt acutely aware that increasing borrowing costs could hinder growth in the economy at a time when, post-Brexit, it is still seen as fragile. In addition, the bank has highlighted high levels of consumer debt and may be wary of adding to debt servicing costs at a time when real people are feeling the squeeze of high inflation and low wage growth.

“The BoE is no doubt acutely aware that increasing borrowing costs could hinder growth in the economy at a time when, post-Brexit, it is still seen as fragile.”

If rates do stay where they are we would expect a sell-off in sterling in the short term. We remain confident that, over time, the currency would still rise from its depressed levels, but a hold in rates tomorrow may mean it takes a little longer.

It is also likely that we would see gilts claw back some of the losses they have seen in recent months, with domestic equities taking a hit. Any short-term rise on the back of BoE hesitancy would not change our view on gilts – that they represent poor long-term value. And with our UK equity holdings focused on quality stocks with international revenue streams, we would see minimal impact compared to the broader market.

 

Looking further out

Some commentators believe that a rate rise this week is only the beginning. They say it will be the start of a series of hikes throughout next year to strengthen sterling and shrink September’s 3% inflation figure back to the BoE’s 2% target. It’s worth remembering that, if interest rates return to 0.5% as we expect, they will still be at historic lows.

But we think UK retail prices have just about peaked anyway, and expect inflation to fall slowly throughout 2018 as inflationary pressures from last year’s drop in sterling work through the figures.

We will be taking a close look at the central bank’s economic forecasts, presented in its Quarterly Inflation Report also published tomorrow, to gauge its appetite for future rises. Is this just a straightforward reversal of the post-EU referendum cut, or the start of a series of hikes? 

The MPC is likely to be very cautious in its language as Brexit clouds loom and its members will want to keep their options open as events unfold over the coming months.

KEY TAKEAWAYS

If the Bank of England raises interest rates this week, it should mean business as usual for markets as everyone is expecting it. If it doesn’t, sterling would slump short-term but still return to historic levels eventually. The central bank’s Quarterly Inflation Report, also out tomorrow, should give a good indication of its long-term view.

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