"Yes, of course interest rates and yields can rise, just not by very much!"
This has been a (very) consistent UK theme for us on the road over the last two years, but does the recent hike by the Bank of England change things?
The theme has been driven by the extent to which ZIRP (zero interest rate policy) and central bank buying have become hard wired into personal and corporate balance sheets.
With bond bears licking their lips ahead of the start of a move towards a more 'normal' rate of interest, I can only imagine their disappointment as accompanying comments from Mark Carney sent gilt yields lower on the day. Ten-year yields closed at 1.26% from 1.34% prior to the announcement. This is equivalent to a price rise of around 1%, so ironically a rate hike has eased financial conditions!
It’s hard to imagine how Mark Carney could have agreed with us any more than he did yesterday as previous guidance to ”higher rates than markets imply” was dropped.
However, even we were surprised by how explicit he was in predicting only two more 0.25% rises in the next three years with “all members agree that further rises will be limited and gradual”.
Given the risks to consumption from continued real income pressure, we still believe that the economic risks are to the downside and that any gilt price weakness will be both limited and short lived.
We also continue to defend duration. If you're going to hold the appropriate allocation to fixed income, it demands that duration is embraced rather than shunned; only then is the asset class an effective diversifier. It can also only then protect you by delivering strong potential capital gains when you need it to, ie. when recessionary and deflationary pressures rear their heads again, which they surely will.
The sell-off in gilt yields could be an unexpected opportunity to top-up just when gilt bears thought their day was finally coming...