With their respective economies improving, many may feel that interest rates in the UK and US are long overdue an increase...
Rise of the interest rates
With their respective economies improving, many may feel that interest rates in the UK and US are long overdue an increase. A UK base rate of 0.5 percent has been in place since 2009 and in the US rates have languished at 0.25 percent during the same period. However, despite the ongoing recovery, the economy is only back to its pre-crisis level and in the UK inflation of 1.6 percent (August 2014) is still below the ‘old lady’s’ 2 percent target.
The need to tread carefully is further enhanced by a lack of slack, ie, minimal wage inflation. Despite the UK unemployment level sitting at 6.2 percent and continuing to fall, stagnant wages and a lack of wage pressure is a conundrum for policymakers. Certainly, noise levels around potential rising interest rates are becoming louder.
In the UK, among voting members of the Monetary Policy Committee (MPC) and in the US the Federal Reserve’s policy making committee, voting has shown a lack of consensus. Indeed, in August we saw, for the first time since Mark Carney’s arrival at the Bank of England, a dissent in voting with the MPC divided over interest rate policy. Across the pond, members of the Federal Reserve’s policy making committee departed publicly from the decision to keep the language surrounding interest rate rises the same.
The most recent FOMC (Federal Open Market Committee) communiqué reiterated that interest rates will remain low for a “considerable time” after the ending of its quantitative easing programme in October. What “considerable time” equates to is difficult to answer, but Federal Reserve chairwoman Janet Yellen has said there is no “calendar date” for a rate rise. Clear as mud then?
However, regardless of market participants scratching their heads in wonder, the focus should be that rates will increase (certainly in the UK and US) sooner rather than later. For what it’s worth, we expect the first rate rise in the UK to occur in Q1 2015 with the Federal Reserve likely to raise rates in late Q2 2015.
For captive insurers, once rates do begin to rise, low bond yields look less attractive, so prices tend to fall and yields rise. There are two possible outcomes for captive insurers with bond portfolios. Captives that buy bonds at low yields could be locking in uncompetitive returns or face a capital loss if they sell before maturity.
To address the first scenario, it’s imperative that the duration of the bond portfolio be kept relatively short and be actively managed to take advantage of the rising rate environment when it finally arrives, whilst being firmly focused on any potential credit risks. The second outcome can be avoided by formulating a bespoke investment strategy for the captive—matching assets with liabilities, but also remaining vigilant around credit risk (something an active bond manger is paid to do on behalf of the captive). Remove the need to sell a bond prior to maturity and avoid a capital loss in a rising interest rate environment—buy and hold to maturity.
When all is said and done and as already pointed out, central banks appear in no hurry to raise rates. Indeed, in Europe and Japan, bond-friendly monetary policies are still being actively pursued and as a result will continue to offer bond investors in these regions a refuge.
Bond price hike
When quantitative easing began in the UK in 2009, investment experts questioned the wisdom of lending money to the government for 10 years for an annual return of 3 percent. Indeed, you might expect that as governments issue billions of dollars, pounds (trillions of yen…) worth of new bonds to bridge the gap between spending and tax revenue, the prices of those assets would fall.
That’s the usual result of a big increase in supply. This scenario partly played out in the UK. In 2010 when yields rose (bond prices fell) to 3.8 percent, the ‘Bond King’ Bill Gross warned that gilts were “sitting on a bed of nitroglycerine” and were “a must to avoid”. By the summer of 2012, 10-year gilts were trading at a yield of 1.4 percent, a record low.
This year was supposed to be different with many financial commentators predicting the 10-year gilt would move closer to 3.5 percent. Yet again the experts have made the wrong call on bonds as prices have risen and not fallen, with the UK 10-year currently around the 2.4 percent level. The movements of bonds has been even more dramatic with 10-year German bonds yields below 1 percent for the first time. Debt sold by European countries that once faced a forced exit from the eurozone has attracted levels of interest that would have seemed incredible two or three years ago. Greece, for example, sold €3 billion of five-year debt in April at a borrowing cost of 4.95 percent, and so the onward march of Teflon bonds continues.
Set against a supposed improving economic climate, there are many explanations for the conundrum of falling bond yields and rising bond prices. The list compiled below is non-exhaustive, but it does highlight some of the more logical arguments put forward to explain the riddle:
Beyond the reasons highlighted above, an implicit belief exists among some that the bond market has it right and low yields are the new norm.
Notably, a conviction held by the bond management giant PIMCO explains that economies will generally grow more slowly, due to a deleveraging of historically high debt levels across the globe. So the theory goes that because fragile economies and consumers cannot handle normalised interest rates, central banks will be unable to raise them.
For those having difficulty falling asleep at night you can always refer to a recently published report from the Centre for Economic Policy Research (CEPR) called Secular Stagnation. It highlights the ongoing “unmistakable signature of the growing shortage of safe assets [and] the secular downward trend in equilibrium real interest rates”.
If the supply and demand characteristics for high-grade government debt have changed, along with expectations for any interest rate increases, we can further understand why both US and UK government bonds have rallied, and perhaps why they’ll continue to perform. Worst case, the reading will put you soundly to sleep.
