22 Sep 2023
While lower for longer was the mantra of the last decade, there is a new catchphrase in town - higher for longer. As income-seeking investors adjust to this new environment, our fixed income investment team outline why the high-quality class looks well placed to command increased allocations and deliver relatively attractive risk-adjusted returns.
Money market rates are anchored by SONIA (the Secured Overnight Index Average), which is the rate at which banks and other institutional investors borrow from each other overnight, which in turn is influenced by the rate set by the Bank of England (BoE). Overnight rates tend to be slightly lower than the BoE base rate but buying instruments with a term longer than one day can generate higher yields.
Money market funds have the flexibility to purchase instruments with a maturity ranging from overnight up to one year, while bank deposits are much more limited in scope to generate income. As a result, bank deposits tend to be less reactive to rising rates (per chart below). The FCA recently published a review of the bank savings market, which found that from January 2022 to May 2023, only 28% of the UK base rate changes were passed through to consumers.1
Pass through of interest rate hikes is much quicker in money market funds than bank deposits
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Source: Fidelity International, Bank of England, June 2023. Bank average interest shows the monthly average of UK resident banks' sterling weighted average interest rate, interest bearing sight deposits from individuals and individual trusts (in percent) not seasonally adjusted. Fidely Cash Fund yield shows the yield as at 30 June 2023 (gross of fees).
1https://www.fca.org.uk/publication/multi-firm-reviews/cash-savings-market-review-2023.pdf
Previous cycles tell us that interest rates have trodden a different path up to the summit than is usual. For so long, the BoE (and other central banks) were behind the curve and playing catch up to inflation, which led to them to pursue such an aggressive set of hikes. In the UK, until recently, market conditions were not actually in restrictive territory. The BoE stands out as the central bank which it still grappling with this challenge, as inflation remains stubbornly above target. The UK inflation rate stands at 6.8% (as of July print), which is still three times its target, leading the BoE to say that it won't be satisfied until inflation falls back down.
In our view, central banks made a huge faux pas in underestimating how strong inflation would be and how long it would stay sticky for, so it’s more than conceivable to think they will continue to pursue an aggressive policy stance. What this does mean for money market investors is that rates are likely to remain at elevated levels for some time.
Market pricing for the future path of UK interest rates
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Source: Fidelity International, Bloomberg, 11 September 2023.
In fact, looking at forward pricing, not only is the market expecting that the UK base rate will reach 5.75% this year, but the base rate is also forecast to remain well above 4.5% for the next two years. If rates are to indeed stay higher for longer, investors can expect to earn good risk-adjusted returns from cash over the coming years.
One other technicality to mention is the shape of the yield curve, which is currently inverted (see chart below). What this means is that very short-term instruments are paying more than long-term instruments. So, not only are the yields more attractive, but investors aren’t required to take much duration risk to generate them.
The UK gilt curve is inverted - shorter maturities are offering higher yields - which is good news for cash investors
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Source: Fidelity International, Bloomberg, 11 September 2023.
Curves have not been this inverted since the 2000’s - difference between 2 year and 10-year UK gilt yields (bps)
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Source: Fidelity International, Bloomberg, 11 September 2023.
While the backdrop for cash appears positive, for an asset class that prioritises capital preservation as an objective, we think it’s important not to get complacent. As the economic outlook deteriorates, investors will look to cash to provide ballast to their portfolios. Therefore, as managers, we’re still very conscious about liquidity buffers and maintaining those well in excess of the regulatory minimums. Credit quality is the other key issue that we watch closely through regular dialogue with our analysts across portfolio holdings.
Given the volatility we have seen across other asset classes, it’s been a period when cash has very much been king. For the first time in a long while, investors in cash have been able to enjoy both attractive yields and positive total returns. Looking ahead, we think cash will remain an extremely attractive investment proposition, given high yields and low volatility. We therefore expect to see structural allocations to cash in portfolios climbing higher over the medium-term.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Fidelity’s fixed income range of funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The value of shares may be adversely affected by insolvency or other financial difficulties affecting any institution in which the funds’ cash has been deposited. A Money Market Fund (MMF) is not a guaranteed investment. Investment in an MMF is different from an investment in deposits. The principal invested may fluctuate, and the risk of loss of the principal is to be borne by the investor. The MMF does not rely on external support for guaranteeing the liquidity of the MMF or stabilising the NAV per share.