Fixed Income  

Future of fixed income

After all, rising rates and bond prices are inversely related, so investors should care about the negative impact that rising rates have on the fixed income components of their portfolios.

With regard to the direction of interest rates, it makes sense to look at the UK and US together, given their historically high correlation. They are in similar points in their economic cycles and US rates generally tend to drive the direction of developed market rates. Forward interest-rate markets curves for both the UK and US project increases across the yield curves, with two-year yields rising about 80bps to 1.4 per cent, five-year yields up about 60bps to 2.5 per cent, and 10-year yields up about 35bps to 3.0 per cent.

This bear flattening makes sense when viewed alongside the consensus belief that the Bank of England and the Federal Reserve will start raising rates around the middle of next year, pushing up the short end of the yield curves that these central banks have been artificially suppressing. Longer rates will rise less as their respective economies are not likely to rocket beyond the 2.5 per cent to 3 per cent GDP expectations. All this said, the predictive power of the forward rates market has been shown to be poor. This is especially in evidence during the past few years when intermediate rates continued to trend downward, despite forward markets signalling the opposite.

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Data from the past few quarters points to the UK being well on its way to improving growth and employment. Indeed, gains here have been so marked that it caused BoE governor Mark Carney to backtrack on forward guidance regarding the unemployment threshold. The consensus view now appears to be that the BoE will start raising rates next year before the US Federal Open Market Committee.

But caution is warranted here, as it is dangerous to extrapolate recent events into longer-term trends. Though employment is improving, there could still be a considerable amount of slack in the UK labour market, as Office for National Statistics data indicates that current per-capita GDP represents only a 2 per cent gain over the 2008 recession low (versus an 8 per cent increase for the US). The minutes from the BoE’s last few Monetary Policy Committee meetings have revealed that the committee has been discussing whether the self-employed, who have contributed significantly to the growth in UK jobs, are in fact underemployed individuals in search of full-time work. A larger-than-perceived slack in the labour force could translate into lower wage-price inflation expectations, which would help keep a lid on interest rates.

Lower inflation expectations are not the only thing that would cause the BoE to be extra careful with rate increases. The UK housing market will also present a potential challenge. As the Bank rate rises, homeowners with tracker or variable-rate mortgages will feel the pinch as monthly payments increase, taking away disposable income they would otherwise be putting into the economy. This could be meaningful, as retail consumption accounts for approximately two-thirds of GDP. Ostensibly, the BoE will not have to raise rates to control an overheating housing market, as the Financial Policy Committee can implement its new macro-prudential tools to control borrowers’ access to mortgage credit and dampen housing demand.