At the last meeting of the UK Monetary Policy Committee, interest rates were not increased. That was the first decision to hold interest rates following 14 previous decisions to hike the rate higher. The decision was tight, 5 to hold versus 4 to hike by 0.25%. The call cannot be tighter than that. Charlie and I attended a meeting held by the Bank of England for investment professionals, where it was intimated that the 4 who wanted to hike saw it perhaps as a one more hike and done, whereas the 5 who voted against were still in wait and see mode.
The next BOE meeting is held on 2nd November. The decision to add 0.25% will again probably be split. But should the rate rise, will that be the last rise? The peak?
Plateau not Peak
Until recently, theory suggested that just as swiftly as interest rates rise, once they reach the top they should equally swiftly fall. It has always been that way, because central banks tend to push rates up too far until the economy starts to break. The dreaded recession follows and the central banks need to reduce interest rates pronto to fix what they have just broken.
This time their narrative is a little different. Central banks believe they have got this just right, they haven’t pushed rates too high, there won’t be a recession, but instead a nice soft landing. They believe that this time we are going to walk away from this crisis after a gentle touch-down, not the usual crash and burst into flames. Perhaps fairy tales are real, I’m thinking Goldilocks here. Not too much. Not too little. Just right.
Long & Variable Lags
However it is more likely they will over-cook this as usual. We can liken the interest rate rising process to fishing with sticks of dynamite. After detonation the small fish rise up to the surface. They also killed the very big fish at the same time, but they won’t be floating to the surface for months to come. In the meantime the central banks just carry on chucking the dynamite overboard.
Back in the 1950’s, it was Milton Friedman (never to be confused with Morgan Freeman) who best described the inherent problems associated with interest rate rises. The effect of raising interest rates to cool an economy was fraught with over-zealous mistakes, due to “long and variable lags”.
Who are the small fish, who are the larger fish and who are the whales effected by raising interest rates, especially in the UK?
- The small fish are about half of UK mortgage borrowers on fixed rate mortgages that have by now already been forced to re-mortgage and commit to higher monthly payments. Along with anyone with variable rate mortgages or debt such as credit cards and store cards. For some, the new mortgage payments and interest payments are devastating. Unfortunately they were probably not the consumers who were driving up prices and inflation in the first place. They never had much spare to fritter away as they have debt to repay.
- The other half of fixed rate mortgages will need to be refinanced over the next 2 years or so. These individuals have not been affected so far by the actions of the Bank of England. This group of borrowers is the definition of those “long and variable lags”. Many of these borrowers are keeping their fingers crossed that rates will fall before it is their turn to have their mortgage payments go through the roof. They are probably also in the group that is pushing for ever higher wages to pay these higher expected mortgage payments. Asking for high salary increases is inflationary!
- Companies and indeed Governments tend to borrow over fixed terms. Think of fixed term Government Gilts and fixed term corporate bonds. Both of these groups took the opportunity to “go long” with terms of 15 years or longer. Some shorter term debt will need to be refinanced and this will be a problem for an increasing number of companies. Incidentally most US domestic mortgages have 25+ year fixed terms. Here the effects of raising interest rates rates may never be felt at all.
- Finally comes the target market that needs to be “cooled”. The group where the bulk of the wealth is. The group who have been guilty of paying whatever is necessary to get what they want, in effect driving up asking prices and inflation. You need a bob or two in the first place to be able to spend it. Many of you will have guessed who I am referring to. It’s us I’m afraid. The baby boomers, the 55 plus, mortgage free folk. Why have we been happy to drive up prices? It’s because of our once around policy. We were locked up for almost two years and now we want life as back as normal. We need to catch up. We grumbled at the cost but we still chose to pay it. We all know individuals who sadly didn’t make it to this point and we are constantly reminded by our morbidity and mortality.
Adding Petrol to the Fire?
Those in receipt of the State Pension saw a rise of 10% last year. In April there should be a further rise of at least 7.8%. For many wealthier pensioners with independent means the state pension is simply spends. My Mum informed me that her fuel allowance had gone up to £600 this year too. These payments are age related and automatic.
Perhaps the biggest change is the return we can achieve on cash. Whist the main high street banks are not adequately passing on what they should, it is still possible to get a sizeable return on cash elsewhere.
So the group that spends the most and is the target to be “cooled” are net beneficiaries of higher interest rates. They are in the best position to continue to pay higher prices.
It’s easy to see why a disgruntled working population is asking for huge pay increases to catch up.
Where are the Whales?
Is there any rotting flesh out there? Were any Cetaceans killed with earlier sticks of dynamite, but their carcass’ will not float up to the surface for months to come? So far there has been a liquidity squeeze on some pension schemes and banks. These institutions have government gilts on their balance sheets which have actually lost £billions in value if they were ever forced to re-value them in the light of todays interest rates. Several banks in the US and one in Switzerland crossed the line too and were bailed out or bought for peanuts to save the system. The largest property speculation funds in China are on the brink of bankruptcy. The is a huge amount of office property which cannot find tenants and has debt outstanding greater than its value. Developing Nations are close to default on their debts. All potential collateral interest rate hike damage.
The real indicator for central banks is the level of unemployment. So far the rises have been low, but at some point the trickle picks up speed and then it positively floods higher if central banks send rates too high and put companies out of business. The level of un-employment itself is a lagging indicator. The numbers aren’t reported until it is too late and those individuals are placed on “the dole” or whatever it is called today.
You can see the “Goldilocks” scenario of just right is easier to get very wrong.
Why is this important?
We are investors. We are used to seeing growth across our share portfolios and that hasn’t happened really since March. Summers are usually steady and flat, followed by rises from here. We have positioned our portfolios to be deliberately cash heavy in these uncertain times. Cash is doing us no harm at the moment as the annual return creeps ever higher towards 5%p.a.
Like every investor currently, we have the conundrum.
- Do we stick with lots of cash for the next 12 months? -or-
- Is it time to buy more cheap shares right now?
The answer hinges on whether the central banks have pushed too far already and will be forced to reduce interest rates quickly, reducing the attractiveness of cash. (The most likely outcome I’m afraid) Or have the central banks got this round of rises just right, meaning bank rates can be sustained at this level for the next 12 months or so and then gradually reduced? The answer to that question is what all investors are waiting to see resolved before shares, especially smaller shares, start to look very attractive once again.