After the markets closed on 22 February, Moody’s, the credit rating agency, downgraded the UK by one notch to Aa1 from Aaa.
The move was widely expected across the markets after a string of disappointing economic data from Britain in the build-up to Christmas.
The loss of the prized triple-A rating is a political blow to the UK’s chancellor of the exchequer, whose fiscal strategy is built around keeping the cost of serving the country’s debt as low as possible. Indeed, last year Mr Osborne argued, to much fanfare, that Britain was enjoying historically low borrowing costs because the market perceived the UK as getting its fiscal position in order.
Business as usual
Politically the downgrade is a nuisance for Mr Osborne. Economically, however, the market largely ignored the event, having little impact on overall UK borrowing costs.
In fact, UK borrowing costs fell slightly to the lowest point this year just a few days after the downgrade, the exact opposite of what would normally happen in the face of a ratings cut. Sterling fell in early trading on the Monday after the announcement, but in the wider context of a 6 per cent drop in sterling the previous week, the move was inconsequential.
The reason for the lack of meaningful market reaction is primarily because the UK retains control of its own currency via the Bank of England, unlike countries in the eurozone.
As such, UK government debt has retained a safe-haven status for investors to park cash, so a credit downgrade for the UK does not affect this situation. If the coalition were to get into fiscal difficultly, they would simply ask the Bank of England to purchase the newly created gilts directly, ensuring existing bond-holders keep getting paid.
The market is more preoccupied about a change in policy stance by the Bank of England than any downgrade by a rating agency. Since gaining independence from political control in 1997, the Bank targeted inflation directly, attempting to keep it low and stable around its 2 per cent target.
This proved an incredibly successful framework up until the financial crisis struck. In the current environment, with ultra-low rates and multiple rounds of quantitative easing (QE), the effectiveness of the current framework in providing the boost the economy requires is in doubt.
Conventional monetary policy runs into problems when rates approach the zero lower bound, which is when QE is rolled out. But it is becoming clear that expectations of easing play a large role in its effectiveness. As the market adjusted to the unconventional policy, its ability to stimulate the economy has declined. QE, therefore, is suffering from diminishing returns.
Tricky business
The Bank of England finds itself in a difficult situation. It has repeatedly suggested monetary policy is at the limits of its effectiveness, yet the chancellor chose to ignore the hint. The downgrade by Moody’s was always going to be either a chance for a change of direction for Mr Osborne or a redoubling of efforts to make the current plan work. He chose the latter, forcing the BoE to remain economic stimulator-in-chief for the remainder of this parliament.
The Bank is choosing to do this by changing market expectations of its policy framework. The incoming governor, Mark Carney, is sewing the seeds for a change of direction away from direct inflation targeting and more towards promoting growth, a more dovish stance.
The net result will be above-target inflation for a considerable period. The BoE even confirmed this in its recent inflation report and in its most recent minutes. This is worrying news for investors. Inflation kills bond investors because payments remain in fixed amounts. This is also the reason for sterling’s recent dive against the euro and dollar.
Options for investors
To protect against rising inflation investors should be looking outside the traditional fixed income space for products with bond-like features but with the added ability to withstand prices rising.
Inflation-linked bonds seem the simplest option, but they are already extremely expensive and became more so following the BoE’s recent announcements. Convertible bonds offer a better current option given they offer the chance of income and capital gain by allowing the opportunity to convert the bond into shares of the company.
Floating rate notes should also be considered given they usually yield more than traditional bonds, providing the extra return needed as inflation rises. The key thing to consider in an environment where inflation is expected to be above target is how to reduce the duration of your fixed-income portfolio.
Blue-chip dividend-paying companies with strong brands also give the chance to create equity bonds, with dividends replacing coupon payments as well as the key additional benefit that companies with strong brands are able to raise prices in line with inflation fairly easily.
Capital protection is the issue here as shares are more volatile than bonds in the short-run, so look for companies that have share buy-back programmes in place. Preference shares should also make up a portion of any portfolio as they also display bond-like features with capital gain possibilities.
Central bank influence across the markets has reached the point where small adjustments to credit ratings no longer matter. Investors are looking at the bigger picture: perceived safety, inflation and exchange rates as the key to return. The market thinks central bank policy is the key to all three in 2013, and it is right.
Alistair Cotton is senior analyst at Currencies Direct
