Interest rates and inflation: expect the unexpected

David Wrigley

Partner

The bottom line:

Gilt yields and long-term inflation expectations are hard to second guess – their changes won’t always be intuitive. Markets will either be pricing in too many interest rate hikes or not enough. Having a balanced portfolio can mean you win either way – or at least never lose too much.

Slowly, then all at once

At the time of writing, we are ten months into a rising interest rate cycle. I would argue our first proper cycle since the Global Financial Crisis, so no doubt there are some key questions for investors now that central banks across the world are taking a strong hawkish stance in an effort to combat inflation. My top three takeaways for investors are:

Markets can behave in unexpected ways and things can change quickly
With that in mind, I’d suggest that most investors should not place big bets on second-guessing the actions of central bankers
Lastly, I believe it is important to 'strike a balance' in portfolios to increase resilience to unexpected rate rises or inflationary outcomes.

…and what a crazy year it has been!

Thinking back to the end of 2021, economies across the globe were coming to terms with normality following a global slowdown due to Covid-19 and high inflation was something that happened in the 70s.

Admittedly by the end of 2021 inflation had been increasing. UK inflation was around 5% at the end of the year, so significantly above the 2% target. Base rates had been increased from 0.1% to a whopping 0.25%. The entire UK gilt curve was below 1.25% pa, which was also the highest base rates were EVER projected to reach.

At the time of writing, most of the gilt curve is above 4% with base rates projected to top 5%.

This clearly portrays how quickly market expectations can change, how wrong market expectations can be.

Markets can behave in strange ways

Within that period, you’d be forgiven for thinking the increases in inflation and base rates translated to expectations of higher inflation and further interest rate hikes. But you only have to look at what happened during the summer to see how unpredictable markets can be. From mid-June to mid-August:

In July UK inflation rose to over 10% (as measured by CPI, 12.3% for RPI);
UK base rates were increased twice, hiking by 0.25% in June and then a bumper 0.5% in August, taking base rates to 1.75% (i.e. far in excess of where base rates were ever expected to peak at the start of the year).

Surely any investor that had long-dated inflation protection was going to do well during this period, and those investors that had bet on higher long-term interest rates (i.e. bond yields) would have made handsome profits?

Instead, longer-term interest rates and inflation expectations both fell between mid-June to mid-August. Of course, with the benefit of hindsight, there will be many rational reasons for this, and many narratives have been written to support the market reaction (which has since reversed).

The point is that markets can behave in ways that are not entirely intuitive and trying to second guess 'what’s already priced-in' is always a challenge.

What can we learn from looking at previous rate rising cycles?

With many thanks to my colleague Imran Hussein for looking back over the previous UK rate rising cycles since 1960, I thought there were two interesting and somewhat surprising observations:

Hawkish periods (where central bankers are raising interest rates) tend to be short lived – whereas markets often price in interest rate rises taking place over long periods.
Historically, inflation still tends to be high even once rate hike cycles have ended – often higher than when rates were being raised (see chart below).

This reflects an important message for investors with interest rate exposure. In a rising rate environment, it’s easy to think rates will stay high so long as inflation is high, and we should expect to see rates tapering only once inflation has been brought back down, right? Well not quite – historically, we have observed that policy rates tend to be brought down ahead of inflation pulling back, as can be seen in the chart below.

My key point is that second-guessing changes in interest rates and inflation, both in the shorter and longer term, is very challenging, can be counterintuitive and I’d suggest shouldn’t be a key driver of returns in most investors’ portfolios.

UK CPI level at the start and end of each interest rate hiking cycle since 1960

Source: Bloomberg

With that in mind, here are my key takeaways for investors:

It is important to have a balanced portfolio, for example, a good split between floating rate and fixed rate assets. Floating rate investments allow you to benefit from further rate rises whereas fixed rate investments allow you to 'bank' the rate rises already priced into markets and benefit you if these rate rises do not materialise.

I’d also suggest that following the huge rise in 'risk-free' rates we’ve seen over 2022 that investors should also revisit their investment strategy to check you are still expecting the returns you need. It will be worth updating your assumptions on future investment returns – clearly, higher returns will now be earned on cash and bonds with rates/yields being much higher. But it isn’t obvious how expected returns on 'growth' assets should follow suit and, for example, how the equity risk premium may have changed.

Finally, for investors that have liabilities exposed to interest rates or inflation, think very carefully about any unhedged positions, as it is far from obvious in which direction interest and inflation expectations will move. Few expected the huge moves we have seen in 2022, so ensuring that your hedging strategies are robust to large market moves are critical with regard to protecting capital.

Here’s to hoping the remainder of 2022 will be more predictable, but I won’t hold my breath.