Future direction of UK interest rates

Following the large fall in long-term interest rates that occurred in 2011, 2012 saw some swings both up and down but they ended at a similar level to where they started, as represented by the graph of the 30 year swap rate shown below.

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Although many people appear to think that it is only a matter of time before they start to bounce back to levels above 4% the reality is that there is a great deal of economic uncertainty around and it is possible to make a reasoned argument that interest rates could actually fall further or simply broadly stay where they are for a significant period.

In the middle of 2012, there were three main international concerns and two domestic issues that were all combining to drive interest rate lower. Internationally there were concerns over:

• the stability of the Euro bloc
• the outcome of the then impending  US fiscal cliff, and
• the Chinese economy and that it would suffer a hard landing.

Although not really impacting domestically, these fears were creating a major flight to quality by investors who were seeing the UK as a haven partly immunised from these primary concerns.

Domestically, the key drivers were:

• the inability of the UK economy to show any growth, and
• the ongoing Quantitative Easing (QE) programme that was buying large swathes of the longer dated gilt market.

Since then, the mood has changed slightly as the immediacy of the international concerns has somewhat reduced whilst the QE programme is currently on hold as the Government tries the alternative approach of the Funding for Lending Scheme.

But in truth, none of these issues have actually been solved or disappeared – the international issues have merely become less immediate and there is a chance that any one of them could return to crisis mode over the next few years. At the same time, as recent releases have shown, the UK economy is struggling to avoid a further recession.

Where might sterling interest rates go?

Higher

For interest rates to go meaningfully higher from current levels, one of four things would need to happen (possibly all together)

• A removal of the international concerns referenced above that would allow all the investors that invested in gilts as the safe haven option to reverse that trade. This has already started to be seen in the FX market as Sterling has weakened against the Euro by about 10% over the last six months.
• A meaningful recovery in the UK economy (possibly associated with an unwind of current QE holdings).
• A material uptick in inflation expectations that meant that the Bank of England became more concerned about inflation as opposed to immediate growth prospects.
• Ironically, a loss of confidence in the management of the UK economic situation to such an extent that investors start to demand a UK premium as we have seen in the last three years in the Euro market. This is also tied to a downgrade of the UK AAA credit rating.

Lower

Although low by UK standards, when compared to other yield curves, evidence would suggest that we have not yet reached an absolute floor on the level of UK rates. The graph below shows the current level of interest rates for Japan, Germany and Switzerland and as you can see UK rates are higher than all of these ‘comparators’.

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In addition the graph below shows a historical track of the Japanese Government bond yield showing that rates have actually been even lower than they are now and that periods of low rates can persevere for a long time.

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In addition, any meaningful worsening in the international situation could well start to drive global rates lower again and as stated above there are certainly chances that:

• the US debt ceiling will not be resolved with further stand-offs within Congress
• the European crisis will re-emerge as the peripheral countries fail to generate sufficient growth to overcome the potential social unrest generated by the high levels of unemployment, particularly amongst the youth, and thereby fail to meet the current budgetary targets, and
• China fails to avert a hard landing as the effects of an international slowdown cannot be sufficiently  offset by rising domestic demand.

By recent standards, it would seem possible that at least one of these could re-emerge over the next few years.

Stay similar to current levels

Without a major improvement in sentiment or a marked financial crisis, it is likely that longer-term interest rates will probably stay within a 50bp move of their current level. It is unlikely that the Bank of England will make any upward move in base rates until they see a meaningful and sustainable improvement within the economy (particularly as other Central Banks remain in an easing mode) and this will constrain the ability of longer-term rates to move any higher.

The Andrew Sentance view regarding winners and losers in a flat market would sit well with this scenario of minimal move in longer-term interest rates.

Which scenario will prevail?

Almost impossible to call but all three scenarios are eminently plausible. Whilst history would suggest that the US will find the energy to deliver a meaningful recovery and that China will successfully manage its transition over the medium term, the downside risk is not trivial both with regards to the potential for things to derail the existing tentative recovery and the fact that many other countries have yields far lower than current sterling levels.

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