24 Oct 2024
Liam O'Donnell
FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed.
So the Bank of England finally cut rates. It was a knife-edge decision, with the monetary policy committee voting in favour of cutting rates by just five votes to four. In the press conference that followed, Governor Bailey pushed back against expectations that another cut would follow at its next meeting, emphasising that the Bank is not on a preset easing course.
This made sense, as measures of core inflation have been stickier than headline readings, and wages are still above levels consistent with the Bank’s inflation target. Yet, despite this guidance, markets are priced in anticipation of a further 110 basis points (1.1%) of cuts over the next 12 months1. So, who are we to believe – the market? Or the Bank of England?
One way to explain this discrepancy is to look back at previous rate-cutting cycles. I looked at four major rate-cutting cycles – in 1990, 1998, 2001 and 2008 – and compared what markets thought would happen with what actually happened. The gap between expectations and reality might surprise you.
In previous rate-cutting cycles, borrowing costs fell by more than the market currently expects
In all four instances, rates fell further than markets expect to see this time. Even in the shallowest cutting cycle (2001) rates fell by 2% within 18 months. And during rate-cutting cycles that extended beyond a year, rates fell by 4%2 on average.
This raises an important question: did investors at the time expect the Bank to cut by as much as it subsequently did? This is where things get interesting. You might say “all cycles are different, and 2024 doesn’t look like 1990 or 2008”. That’s entirely fair. But I find it striking that, on all four occasions, the market underestimated how far rates would fall.
On average, just before the Bank began easing, the market was pricing in cuts of just more 1% over the next 12 months. (That’s about what investors expect today.) In the event, however, rates were actually cut by an average of 2.75%.
Not surprisingly, markets were even worse at predicting how far rates would fall on a two-year horizon. Again, they expected rate cuts of just over 1%. But, on average, cuts of just over 3.5% followed. In 2001, the forecast was for rates to rise marginally on a two-year view. They actually fell by 2%.
What are we to conclude from this? My interpretation is that we should expect rates to come down by more than markets are predicting, pushing bond prices significantly higher.
Why the Bank may need to cut rates by more than the market expects
Why might policymakers need to cut rates more aggressively than is currently being priced in? The pessimistic view is that what currently looks like a ‘soft landing’ could turn into something much less comfortable. Unless central bankers have become much better at gathering and processing market data, past experience suggests that rates will be lowered too slowly. And not just in the UK – we have recently seen anxiety about the US Federal Reserve being too slow to move.
To be clear: I am not blaming the central bankers for this. Fine-tuning monetary policy is an incredibly difficult task. Policymakers mostly rely on historical data. It is like driving a car while looking in the rear-view mirror. Monetary policy, meanwhile, acts with a lag. That can mean the signal to change direction arrives too late and the moment to start gently turning the wheel has already passed.
Investors can prepare for rate cuts by locking in today’s attractive yields
Today, the top five-year fixed-rate cash savings account is paying about 4.3%. You can get about 4.6% over three years. A good corporate bond fund, however, could offer a higher starting yield and potentially deliver significantly greater total returns over the coming years.
Let’s imagine a typical corporate bond fund might have a starting yield of 5.5% with a duration of six years. In simple terms, that means its holdings are expected to pay a yield of 5.5% a year. Even if rates do not tumble, that looks attractive.
But if interest rates do fall by more than expected over the next year, these bonds will be repriced. Assuming there are no defaults in your chosen fund, simple maths says you should see a 6% rise in the capital value of your fund if interest rates are cut by 1% more than the market currently expects. Any further unexpected cuts will see the capital value of your bonds rising again. Owning a good corporate bond fund enables you to lock in high rates for longer while also adding some insurance to your portfolio in the event of a hard landing in the economy.
I’m a bond investor, rather than a historian. But my interpretation of the recent history of monetary policy in the UK suggests that bonds may be a particularly attractive buy at the moment. Market history doesn’t repeat itself – but it often rhymes.
Source for all information: Artemis/Bloomberg as at 7 August 2024, unless otherwise stated.
1BOE Interest Rate Cuts: Traders Fully Price Two More Cuts This Year After CPI - Bloomberg
2Source: Bloomberg
FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS.
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