Interest Rate Outlook

Please enjoy the below written by Steve (Steve Williams Parsonage Investment Committee), in which he gives his take on the future or interest rates.

Photo by Jon Cellier on Unsplash

November is a cracking month. While the shadows grow longer, the colours grow deeper and from high in the Cumbrian fells, crowned with cold blue skies, you can see for miles ahead. It’s not often so still up there, clear views are infrequent and fleeting.

Meanwhile, back at my desk and reading the data, I find myself in conditions of poor visibility. The immediate economic outlook is not easy to distinguish. My strategy, for moments such as these, is to try to determine what kind of conditions are currently priced into the capital markets and, from there, identify any points of difference I might have.

The market data suggests that bond prices are consistent with a rate rise, from 0.1% to 0.25%, at the December meeting of the Monetary Policy Committee (MPC) though it seems to me that there is a very good chance of an increase when the MPC next meets on 4 November.

The speed at which the market has adjusted in its expectations for a near term rate increase is breathtaking. A little over a month ago, I was complaining that the market was underpricing the prospects for an earlier shift. The instantaneous forward rate on the Overnight Index Swap at the 12-month horizon hovered at 0.29% on 01 September and it has shot up to 1.13% today. You may have noticed too that the yield on the 10-year gilt has jumped from 0.60% to 1.14%. Those moves have narrowed any difference I had with market prices to the extent that my expectations are broadly in line with those of the market (or my interpretation thereof).

Much as I enjoy the will-they-won’t-they excitement around the timing of the first rate rise, I am more concerned with how far and how fast rates might rise in the months and years ahead of us. The first hike, as I have indicated, will likely amount to just 0.15%. Following on from that, I expect the Bank will move in jumps of no more than 0.25% each time. The timing of the second increase is hard to define, but I think today’s market prices are consistent with a rate of 0.5% by the time of the February meeting.

Questions around the timing of the second rate rise are particularly pressing, since under previously stated plans the Bank will begin to unwind its asset purchase programme (QE) when Bank Rate reaches 0.5%. It will do so by ceasing to reinvest the proceeds from coupon and principal payments, leading to a natural drawdown in the amount of gilts held on the Bank’s balance sheet. Natural, but not necessarily gradual. March 2022 sees a particularly busy schedule of payments amounting to close to £30 billion. Thus far, the excitement has been at the short end of the yield curve but the prospect of a much-diminished balance sheet could broaden the focus a little.

Beyond that, prices in the bond market are consistent with a third rate rise during Q3 and a fourth during Q4, lifting Bank Rate to 1.0% by the end of next year.

After that, the yield curve is flat all the way out to for five years. Actually, there is something of a hump in the forward-rate yield curve. Specifically, rates increase out to the 18-month horizon to peak at 1.2%, before they fall back to 1.0% at the 36-month mark. That suggests to me that the bond market is skeptical that the Bank of England is embarking on what will be a series of sustained increases. Either the Bank takes us to 1.0% or 1.25% and gets stuck there, or it is forced to reduce rates thereafter – both suppositions are consistent with market prices, though the second is the better fit.