UK inflation and interest rates – what happens next?

As the recent “surprise” inflation figures demonstrate, trying to predict what will happen with inflation and interest rates in the UK currently is a mug’s game. Unfortunately, as a bond fund manager, I am paid to be that mug. What we buy – gilts, corporate credit, long duration, short duration – depends on the decisions we expect central banks to make in the coming months. And that depends on what is happening in the wider economy.

Opinions among bond fund managers are divided and markets more widely have changed their minds significantly in the past few months.

At the beginning of the year they were forecasting UK interest rates to be 4% in March 2024. By mid-July that had increased to 6.5%. It has since moderated to 5.8%. Rate expectations are now around the same levels seen at the time of the Kami-Kwasi Budget last October. The base rate is currently 5%. But inflation is still much higher at 7.9%.

Clumsy

Raising interest rates is a clumsy tool for cooling the economy and dampening inflation. With so many people on fixed mortgage deals and so many businesses locked into long corporate bond arrangements at low rates – with five, 10 and even 30 years to maturity – it takes time for the impact of a rate rise to work its way through to the economy.

Undoubtedly, though, the impact is coming. The Bank of England estimates that one million households face an increase in their monthly mortgage of £500 or more by the end of 2026 – a hike of £6,000 a year. You have to be on a pretty high salary for that not to hurt (and the median full-time salary in the UK is just over £33,000).

Central banks generally have a poor record of managing these situations. The danger is that the Bank of England will carry on tightening the screw when it does not need to – unaware that it is fixing the country on a path for a deep recession from which it will struggle to escape.

Inflation and interest rates look like they may have peaked elsewhere in the world. In the US inflation is down to 3% from 6.5% at the start of the year, and many say the Fed can stop lifting rates now (currently at 5% to 5.25%). The US appears to be on the trajectory of a soft landing – the so-called “Goldilocks scenario”. China cut its rates recently. So did the Bank of Hungary.

So now may be a good time to lock in higher yields offered by bonds.

The UK has worse problems than most. It has the highest inflation rate of any Western European country. We can blame Brexit. EU residents returning home have not helped the tight labour market, which is driving wage inflation here. But the UK has always struggled more than most with inflation.

Goldilocks or bust?

In the end, the causes of inflation matter less than the course of inflation Ask me what I think will happen next and I have to say I am bamboozled. Forget both Goldilocks and the many that have been telling us for months that the sky is falling. If it is, it is taking its time. The lag between rate hikes and the impact on the economy is well known – but now people are saying its two years rather than one. Though the employment numbers seem to be off their peak, I fail to see how we have meaningful recession without meaningful unemployment. And we are a long way from that yet. I could make a case for being bullish. But, in all honesty, it would be half-hearted. I just do not know.

In such times I do not think you can invest for one scenario or the other with high conviction. As a consequence, we are modestly long duration. We have been adding a little to duration in recent weeks.

In terms of corporate credit, the vacuous comment so often made at these points is that what matters is careful credit selection. Everyone says it but I have never met a professional investor that throws darts at a board.

That said, we are seeing bigger dispersions with the market. Years of low yields have allowed leverage to build up. Now yields are much higher that’s a problem. Take the water industry. Thames Water, which is highly levered, is vulnerable. The bonds of other water companies are trading well, however. Within the logistics real estate sector, similarly, Segro and Logicor are experiencing radical differences in where their bonds are trading. We own both, but the more leveraged players in any given sector are now seeing a much bigger differentiation in the yields on their bonds.

I believe the increased cost of funding is going to manifest itself not at a sector level but on individual companies. Many have been savvy in locking in cheap rates on long terms. With their bonds years off maturity, these companies have plenty of time to earn their way into a better capital position if they need to. Others, borrowing afresh, are facing a big leap from the zero-bound interest rate environment they have been used to. There will be isolated cases of companies struggling. But I do not see a systemic issue.

For me that means bond markets are a good place to be. Yields have risen, and I do not think you have to take a strong bet on the direction of inflation and interest rates now to achieve a decent return. The secret is to be nimble – quick to seize opportunities when they open up and the outlook may be clearer.

Stephen Snowden is Head of Fixed Income at Artemis