Base rates at 2% this year? Not a 'snowball's chance in hell'

UK government bond yields have been rising in recent months to reflect the reality of higher inflation and base rates.

But Snowden said the market has been presently pricing in inflation remaining at elevated levels for a long time, and so believes this will prove transitory and force central banks to be more cautious on rate rises.

He said: “To a large extent, inflation is the cure for inflation, as we are now seeing with higher supply-side inflation causing economic growth forecasts to be revised downwards.

"That will, in time, lead to inflation falling from the demand side."

The factors that are causing the inflation are transitory

He said it was also worth noting that the Bank of England has said it will also use quantitative tightening to address inflation, not just interest rates.

Snowden added: "I think it is accepted now that policy makers should have tightened policy earlier, and they are now playing catch-up.

"But I think a combination of using quantitative tightening and the more transitory nature of the inflation means there is not a snowball’s chance in hell we get rates at 2 per cent this year.” 

Julian Jessop, an independent economist, said that rapid expansion of the money supply over the past 18 months had helped to create the much higher inflation we are experiencing now, but that more recently, as a result of central bank action, money supply growth has slowed dramatically, and this should lead to inflation falling soon. 

In the spring statement, the Office for Budget Responsibility forecast that inflation would peak at 10 per cent in the UK this Autumn, before dropping back, but still estimated it would average 7.4 per cent this year, higher than the present 6 per cent level.

James Klempster, deputy head of multi-asset at Liontrust, is quite optimistic on the economic outlook, noting that “while growth forecasts have been cut, the actual level of growth is still higher than we have seen for most of the past decade.

"While inflation is high, there are few signs so far that it is becoming entrenched in the system. The factors that are causing the inflation are transitory, really they are a series of transitory factors that will wash through the system.” 

Counting the cost

Thomas Wells, who runs the inflation linked bond fund at Sanlam said producer’s reaction to the current higher inflation may itself cause inflation to last longer. 

He said: “Perhaps the more worrying issue is what businesses and companies do in response to soaring prices.

"In the agricultural sector, we are hearing that farmers are choosing not to plant crops because energy and fertiliser prices are unaffordable, and/or they are concerned that, come harvest time (when energy prices may have moderated) food prices may also have dropped and they won’t be able to recoup the huge outlays that need to be made now.

"Many companies will have made up their own mind on inflation and indeed the Institute of Directors confirmed as much this week when it said that inflation is now ‘hardwired into routine business decisions.”

There have been many fund managers who have lost their jobs because the market stayed wrong for a long time.Snowden

But he doesn’t expect central banks to change tack, even if the inflation outlook changes.

He said: “ Central banks have been raising rates despite the war in Ukraine and in the US Powell has already made it very clear that fighting inflation and stabilising prices will be prioritised, even if that means a hit to GDP growth.” 

Despite his view that inflation and interest rates may not rise to the extent the market presently expects, Snowden is presently invested as if they will. 

In normal market conditions, if interest rates rise by less than the market expects, one would expect short duration bonds to perform poorly and long duration bonds to perform well, but Snowden is, for now, investing in line with the market view by owning more short duration bonds.

Snowden added: “As fund managers, we are not paid to be right about economics, we are paid to make money for our clients.

"And the reality is there have been many fund managers who have lost their jobs because the market stayed wrong for a long time and they lost their clients' money.

"I would also say, there are technical reasons to stay short duration, mainly that as quantitative tightening happens, that would be bad for long duration bonds.” 

Meanwhile, Klempster is investing on the basis that growth will continue to be robust, and interest rates will rise, and so has his portfolios tilted towards value type equities and with much reduced allocations to government bonds.

david.thorpe@ft.com