November 2017

November 2017

Commentary

Although this is the newsletter for October, it would seem churlish not to include reference to the sheer excitement of an event last seen in July 2007, namely an increase in the Bank of England base rate. For reference, the ban on smoking in public places had just come into effect, the third generation Ford Mondeo had just been launched and after teasing him for years, Tony Blair had finally handed the keys to 10 Downing Street to Gordon Brown. He wasn’t called Teflon Tony for nothing and his timing was delicious in terms of scale of hospital pass made to Brown. Barely a month later, BNP Paribas blocked withdrawals from three funds with exposures to subprime mortgages, a move which heralded the beginning of the global financial crisis. Come to think of it, the Bank of England’s decision to raise interest rates a touch before one of the most spectacular banking busts in history kicked off in earnest also looks pretty impressive with the benefit of hindsight. Not long after this, the BoE, in line with other global central banks, was scrabbling to push its base rate down to levels not seen before in its 300 year history.

Rates were pushed down to the floor and there they stayed…and stayed…and stayed, pushing lower further in the aftermath of the UK vote to leave the European Union. Indeed, zero bound interest rates and Quantitative Easing programmes, which were presented as “emergency measures” remain in place today, with the argument that the economic recovery hasn’t been sufficiently strong to justify their reversal. An alternative explanation might be that the medicine hasn’t worked but that’s a separate debate.

Nonetheless, the baby step of a 0.25% move towards “normalisation” of rates had been very well telegraphed with rate setters responding to inflation increases, the lowest level of unemployment since 1975 and continued sterling weakness (which itself has an inflationary impact). Nonetheless, the MPC minutes were interpreted by the market as being more dovish than expected and gilt yields and sterling both fell in response to a view (denied by the Bank) that the increase is a “one and done” move. Stepping back and looking at the chart above, the move from 0.25% to 0.5% looks so insignificant as to barely warrant the attention received against a historical average rate of nearer 5%.

Of course, the key question exercising finance and treasury minds is whether this is a one-off increase by the Bank both to send a message to the market and to test the market’s reaction, or whether it signals a more sustained shift in direction and indeed market psychology after years of accommodative monetary policy. With the headwinds of Brexit uncertainty, falling real wages and a slowing retail sector, our bias is towards the former rather than the latter and we would recommend caution in clients reacting too much to this rate increase. In any event, most of our clients have heavily fixed rate treasury portfolios and are therefore already well protected against higher moves in rates.

All the while, housing associations continue to access very attractive long-term rates in the sterling market with little sign that recent ratings actions by Moody’s have reduced investor enthusiasm for HA debt. The table below shows the recent flurry of issuance by housing associations with all in coupons ranging from 3.125% to 3.288% with maturities out to 2049. Centrus was pleased to have advised two of these issuers, Catalyst and Housing & Care 21, both of which achieved excellent results for their debut issues.

We of course do not have a crystal ball when it comes to the direction of interest rates. But I would lay a decent wager that at some point between now and 2049 some fund manager will review an inherited portfolio and scratch his or her head and wonder what on earth possessed their predecessors to acquire a 30-year bond at the low point in the interest rate cycle and offering such a paltry rate of return. I may of course not be around to make good on the bet by then but that’s long-term counterparty risk for you. Meanwhile, for housing association borrowers looking to underpin their business plans with long term fixed rate funding, this remains something of a golden period.

Financial Markets and Economics Overview

With a 7-2 majority in favour of a rate rise, the BoE increased interest rates for the first time since July 2007 from 0.25% to 0.5%, maintaining its plan for gradual and limited further increases in the future. This move was largely expected by markets. The rate hike comes from the back of increasing inflation, hitting 3% in September, the highest rate since April 2012. This increase in inflation has partly driven by depreciation in Sterling vs. other major currencies; over the last 3 months the pound has remained 15%-20% below its November 2015 peak. The effects from depreciation are still passing through and with external factors such as global oil prices being 17% higher than at the start of August, the BoE views that inflation will peak at 3.2% in October and then gradually fall back over the next year. In other news, BoE’s corporate and government bond purchasing programme was maintained at its current levels of £10bn and £435bn respectively.

GDP growth remains modest at 0.4% in Q3, which is 0.1% higher than expected 3 months ago. The sluggish growth can mainly be accounted for by a slowdown in the services sector, as well as a real income squeeze on consumers, as they adjust to the impact of depreciation. Despite this, the economy has seen positive signs within the manufacturing sector, where October’s PMI came out at an encouraging 56.3 beating market expectations of 55.9. The released figure puts the tally at 15 months of consecutive expansion.

Annual house price growth rose 2.5% in October, as indicated by the Nationwide House Price Index. This resembles an increase of 0.2% from September and it can be attributed to a shortage in homes and low mortgages within a stable and highly competitive mortgage market. However, the impact on house prices has been subdued due to lower consumer confidence stemming partly from falling real wages. It is expected that the 25bps increase in rates is unlikely to have a material impact on variable rate borrowers.

1-month and 3-month Libor have both steadily increased to 0.40% and 0.44%, respectively, which is in line with market expectations of the recent rate hike. Swap rates and gilt yields have seen very little movement over the last month.

The chancellor, Philip Hammond, is due to present his Autumn budget this month and faces multiple challenges, the biggest of which comes from low productivity growth that is expected to squeeze public spending over the next few years. Despite the increase in demand for public spending, he stated last month that he would not break the fiscal rules he set out a year ago, which aims to reach a budget surplus by March 2020.

Interest Rates

Inflation

Capital Markets

Bank Credit