A hike in UK rates may be no walk in the woods

Following 8.5 years of near-zero interest rates and months of conflicting, confusing and contradictory signals from central bank officials, the Bank of England (BoE) finally raised its base rate from 0.25% to 0.50% on November 2. The move was widely expected and both the pound and long-term bond yields had risen significantly in anticipation.

However, on the day the decision was announced, the currency lost 1.4% against the USD and the 10-year Gilt yield dropped by 9 basis points. The monetary policy-sensitive 2-year rate also decreased by 8 basis points, as markets initially misinterpreted the Monetary Policy Committee (MPC) statement of “limited” and “gradual” rate increases as dovish. Since then, the 2-year Gilt yield has gone up again, but still remains below the base rate of 0.50%. Overnight index futures now predict two more 25-basis point hikes over the next 1-3 years.

This differs from the two most recent hiking cycles of 2003/4 and 2006/7, in which the BoE raised rates in five increments of 25 basis points each over a period of roughly 12 months. We examined those historical precedents in a recent study, published in October, in which we stress-tested a GBP-denominated multi-asset class model portfolio through the two periods. We also performed a number of so-called transitive scenario analyses that replicated the original curve movements from the historic periods, but used the current correlation structure to populate the remaining pricing factors (stock returns, currency exchange rates, credit spreads, inflation, commodity prices, etc.).

Throughout all scenarios—historical and transitive—we found a strong positive relationship between short-term interest rates and equity returns, meaning that the UK stock market would be expected to go up when the BoE raises rates. This was indeed what we observed, when the FTSE 100 index gained 1% in the days following the MPC meeting, although the move was credited more to the drop in the pound, based on the argument that a weaker exchange rate makes exports from British companies more competitive and increases the value of foreign earnings.

The sterling depreciation observed after the rate decision seems to contradict the findings from our stress tests, which almost all indicated an appreciation versus the USD. The latter makes sense, in our view, and that is indeed what happened when markets started to seriously price in the rate move. The drop in the exchange rate was most likely simply a reaction to the seemingly dovish language from the MPC, and GBP/USD has, in fact, already recovered to pre-meeting levels. Any signals from the Bank of England that the next rate hike might come earlier than what is currently priced in should be positive news for the pound.

In both historical periods, we observed an inversion of the Gilt curve. It is too early to say whether we will see a similar move in the current cycle. Much depends on how the Bank of England proceeds over the next couple of months. Even if the BoE were to increase rates by the same amount as in the past (five steps of 25 basis points each), the final level of 1.5% would still be below the current levels of long-term Gilts, which yield just under 2%. That said, if the current deadlock in Brexit negotiations were to persist, or if there were a successful challenge to Theresa May’s premiership, an inverted term structure is a distinct possibility.

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Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.