Jim Brooks, Derek Lyons and Tim Hughes give a round up on interest rates and explain why it will make council finance directors happy About three months ago, we highlighted the near meltdown in the 50-year gilt market. Yields had hit a 50-year low. Since that dramatic time, there has been a significant change in the prevailing market view, which has created a spike in yields. This suggests we are going to see interest rates tightening over coming months. If the sterling interest rate futures market is an accurate reflection, this could be a rise of as much as 50 basis points by next March. This would represent a complete reverse from the position six months ago, when analysts and economists across the Square Mile were predicting that rates were going to remain steady or even fall slightly. This feeling persisted, in spite of the Bank of England’s monetary policy committee’s slightly hawkish inflation report in February. So what has happened to turn the markets around? Nothing spectacular has emerged in terms of underlying economic data. The economy is reasonably resilient, and recovery is signalled by stronger-than-expected manufacturing figures. GDP continues to grow evenly, in line with recent trends, the service sector remains robust, and the recovery in house prices has been sustained. Consumer reaction has been muted so far, demonstrated by continued weak retail figures – apart from Marks & Spencer’s. Confidence levels and survey responses have improved, and there is no suggestion of any secondary impacts on increased wage demands from higher fuel costs and higher general inflation. So, we need to look more closely to try to see the reasons for the shift. The Bank of England’s latest inflation report in May indicated that the rate of inflation would breach the 2% benchmark and rise to 2.4% within its two-year focus, if the current ‘repo’ rate level remained unchanged. This was a hawkish outlook and bolstered market expectations further that interest rates were likely to rise. In addition, many of the stronger economies across the world have moved into a period of rising interest rates. In the US, there have been 16 rises from the Federal Reserve. In Europe, the ECB has also started to tighten, as has the position in Australia. The Japanese have flagged that their central discount rate is likely to rise for the first time since hitting its current level in September 2001. This global tightening has contributed to the recent financial volatility in the UK. There has been sharp selling of both the dollar and equities, which has filtered through to interest rate markets. This could presage a long, hot summer of sharp market movements, with no decisive trend likely to appear until later in the year. The uncertainty about the direction of interest rates is reflected in forecasts emanating from the financial institutions. The usual pattern is that most of the commentators give a broadly-similar outlook, with the occasional head appearing above the parapet to suggest an alternate scenario. At present, there seems to be less consensus than usual. Individual members of the Bank of England’s monetary policy committee are also expressing differing views. So we need to keep a close eye for signs of a shift in the ambient noise of the markets. Finally, this upward shift in interest rates will have put a small smile of satisfaction on the faces of many local authority finance directors Encouraged by the record low rates earlier this year, many of them went into the market to borrow, anticipating their capital programme financing requirements for the year ahead. This smart thinking demonstrates the level of sophistication of financial management in local government. w Jim Brooks, Derek Lyons and Tim Hughes are employed at Sector
