The age of negative interest rates is drawing to a close. Good riddance
Great news. Interest rates are rising strongly, returning them to a semblance of pre-financial crisis normality. For the first time in more than a decade – when the balance of benefit has overwhelmingly been with creditors – there is reason to hope that savers are back in the driving seat, or at least soon will be.
OK, so this is not a popular sentiment. The headlines after last week’s interest rate rise, the biggest in 30 years, told an altogether different story, with household finances seemingly trashed by a combination of rising energy bills, food prices and now mortgage costs.
To be welcoming a tight money environment in the midst of an already crushing cost of living crisis and a gathering recession might therefore be thought a tad insensitive.
Markedly higher rates are most decidedly not good news for those with large mortgages and other forms of debt; particular sympathy should be reserved for those who have only just managed to clamber on to the housing ladder. Forced as most of them have been to borrow heavily to afford today’s eye-wateringly high house prices, they now face an especially gruelling squeeze.
Yet total debt within the economy is only the mirror image of total assets and cash deposits. Across the economy as a whole, sectoral borrowing and saving must essentially balance. For far too long now, the gains have overwhelmingly been skewed to debtors.
For every given change in interest rates there will always be winners and losers. The big losers during the era of zero interest rates have been those with cash saving and other forms of near cash such as government bonds, where real returns have been negative.
The winners were those leveraging themselves to the hilt. This relationship is now going abruptly into reverse, and although it will be hard on many households, it is none the less, in many other respects, a welcome development.
Some of the biggest immediate beneficiaries are ironically Britain’s legacy: defined-benefit pension schemes. I say ironically because these funds were also at the centre of last month’s panic in gilt-edged markets, with their very solvency threatened by fast-rising interest rates.
The reason they found themselves in such a hole is none the less instructive. To improve on paltry levels of return, they had been persuaded to take on the leverage of so-called “liability-driven investment” strategies, and therefore found themselves having to dump assets to satisfy margin calls as interest rates rose. The consequent “doom loop” in gilt prices only came about because yields had sunk so low that they were failing to keep pace with liabilities. Riskier hedging strategies, which were of course sold as fail-proof, became the order of the day.
But now that the immediate crisis is over, with the treacherous positions substantially unwound, pension funds find themselves major beneficiaries of rising interest rates; the effect is materially to reduce the cost of funding future liabilities. This in turn eases the pressure on corporate sponsors to plug deficits.
The same is true of other net cash or near cash savers. There are a lot more of them than you might think. Extrapolating from the latest English Housing Survey, only around 30pc of UK households are mortgage holders.
Some 35pc own their houses outright, or in other words, nonmortgaged home owners outnumber the mortgaged ones; such home owners are likely to have substantial cash savings.
None of this is to argue that in the round the beneficiaries of rising interest rates fully compensate for those who are hurt by them. Higher interest rates will always be contractionary, if only because those in debt tend to spend what they earn and will therefore have less disposable income as borrowing costs rise. Whereas those with already high savings are less likely to spend from the extra income they derive from rising rates.
Furthermore, when Bank Rate rises, retail banks tend to be far more partial to raising borrowing costs than deposit rates. And finally, rising interest rates are nearly always damaging to asset prices; what the saver gains in terms of higher income, he loses on the falling price of his assets.
I started this article with the proclamation of “great news”; yet taken at face value, last week’s blood curdling forecasts from the Bank of England look grim indeed.
If interest rates follow the path implied until very recently by financial markets, with Bank Rate surging to 5.25pc, then we are looking at the longest recession since the Second World War, a near doubling in the rate of unemployment and inflation falling to zero in three years’ time.
These forecasts would strongly suggest that the markets have got it wrong, or that interest rates do not need to rise to such an elevated level to meet the 2pc inflation rate. This in any case was the inference drawn by Andrew Bailey, the Bank’s Governor.
If we instead assume that Bank Rate stays at 3pc, you get a rather more benign picture, even if under this scenario, the recession would still last for five quarters. Yet it would also mean that mortgage rates may not need to rise by much more than they already have.
Unfortunately, there are at least three rather important flies in the ointment. One is that the Bank of England’s record in forecasting and responding to inflationary pressures has been particularly poor over the past year and a half.
You would not bet on a sudden improvement. There is a strong possibility that the Bank’s modelling remains trapped in past complacency about the inflationary threat and that policymakers will therefore be forced to act more aggressively than they imagine.
Certainly that’s what the markets believe; market expectations of peak Bank Rate barely shifted after Bailey’s guidance and remain firmly stuck at around 4.25pc.
Second, it is now abundantly clear that there is a costly “British premium” attached to UK interest rates. Whether this is down to Brexit, or to the debacle of September’s mini-Budget, isn’t clear. Rightly or wrongly, the UK is judged less creditworthy than it was relative to the US and much of the rest of Europe.
And finally, it may not matter whether or not domestic inflationary pressures are abating if, in order to support the pound and dampen imported inflation, UK interest rates have to broadly match those of the US, where growth prospects are much better.
Energy self-sufficiency has partially shielded the US from the worst effects of rapidly rising fuel bills, which in turn means that the Fed doesn’t have to be as mindful of recessionary forces in aggressively raising rates as we do in Europe. In any case, the Bank of England finds itself caught between a rock and a hard place.
Wherever rates eventually settle, it is hard to imagine them going back to zero in any foreseeable future, or once a semblance of price stability has been restored, even anything below the prevailing rate of inflation. The age of negative real interest rates is over. Good riddance.
‘There is a strong possibility the Bank’s modelling remains trapped in past complacency about the inflationary threat’