The Bank of England (BoE) will not raise rates as far as the market is expecting, according to Stuart Steven and Jack Willis, managers from the Liontrust sustainable investment team, as it will not stomach the risk of recession and will realise that these actions will do little to stop supply-driven higher prices.
They added this is generating buying opportunities in pockets of the market that have been previously overlooked, particularly among some UK gilts.
“Futures markets are currently pricing in 125 basis points of tightening from the current base rate of 1.75% up to 3.25% by early 2023. We do not think the BoE will be able to pursue tightening to this extent,” they said.
The reasons for this are multiple – the main one being that it would be too late now, as the risk of a technical recession (two consecutive quarters of contraction) is looming.
“The failure to raise rates earlier than December 2021 [when the UK 10-year gilt yield had increased by 80 basis points over the course of the year and was flat in the fourth quarter] looks to be a major policy error. The BoE now faces the prospect of enacting further rate hikes against a backdrop of falling growth,” Steven and Willis said.
In 2022, yields rose by around 170 basis points to reach a mid-June peak of 2.65%, before falling to just around 2% currently, as shown in the graph below.
Yield of UK 10-yrs gilts year-to-date
Source: Financial Times
“The Bank of England has never before undertaken a rate hiking cycle at same time as growth is slowing sharply and a technical recession is possible. History is against them on this front,” said the Liontrust team.
But this is not the only reason why the BoE might decide to go down a less hawkish path, as combating the cost-of-living crisis is also high up the list of priorities.
“While higher interest rates may help take some heat out of the labour market and lower the risk of a price-wage spiral, the BoE will be very wary of further undermining disposable income for many in society by making it even more difficult to afford the essentials.”
Further tightening would also risk damaging particular sectors of the economy such as retail and hospitality that have already been suffering as a result of Covid restrictions.
Ultimately, the inflation we are experiencing now is down to supply shocks, Steven and Willis explained. Prices are not rising due to a higher demand than supply, so tackling the demand side will have limited impact.
“Our base case is that the BoE stops short of taking rates to 3% but accompanies further hikes with rhetoric that is aimed squarely at taming the risk of big second-order effects in terms of wage rises.”
So how to adjust your portfolio in a rising yields environment?
UK gilts are in buy territory, said the team, but not across the whole curve.
In light of the better value implied in the rising yields, Liontrust has moved from a structurally short duration versus the benchmark, which they had maintained in recent years, towards a more active approach.
“While we plan to stay moderately short duration at the current 2% levels, we will aim to manage this quite actively rather than implement a more structural position. Were yields to rise to the 2.25%-2.50% range, we would further reduce our duration short position. If, however, gilts rallied and the yield pushed back to 1.5%-1.75%, we would increase the underweight to duration,” they said.
“The short end of the curve tends to be more policy sensitive, so we favour two to three-year gilts where we expect yields to fall. By contrast, we are underweight the long end as we think 30-year gilts still do not price in the likelihood of a sustained period of 2%-2.5% inflation.”