Rosier forecasts point to a steaming recovery, perhaps too hot for the rates market though…

Economic projections for the latter half of 2021 are looking increasingly good and the Bank of England in its latest report reflected this with a whopping increase in the pace of expected growth. As recently as February the Bank of England had forecast GDP growth for 2021 as a whole to be 5.0%, but they have now raised this to 7.25%, which will make this the fastest rate of growth for the UK in the last 80 years.

Any forecast has to acknowledge a number of uncertainties, but looking forward I am remarkably confident on what is going to be driving the economy at least in the short term. This is not an outlook that depends upon raising productivity (something which has proven to be difficult in recent years and where I do not see matters improving particularly quickly) or consumers taking on a lot of new debt (indeed, consumers have been repaying debt leaving their individual balance sheet in better shape than they were before the pandemic). This recovery is being driven in part by income flows which having been saved are now being spent: at least a portion of those accumulated savings are being splurged by consumers and another portion by businesses with a now clearer idea of where to productively invest.

The importance of “forced” savings

The shutdown of our economies lead to a good deal of “forced” savings over 2020 and 2021 – indeed the savings rate rose from its long run average rate of 6% to touch 27% last summer. The result was an accumulation of savings somewhere north of £200bn, more or less evenly split between savings by consumers and those from businesses. 

Simply moving consumer spending from being saved to being spent, is the first element supporting the economy in the coming months. In addition there is the potential for at least a portion of the accumulated savings to be spent as well: the Bank of England raised its expectation of this from 5% of accumulated savings to 10% in its most recent report. I think this is still too conservative. The central bank’s analysis, based upon survey data, asked people what they expected to do with their savings, with most people saying they intended to simply continue to save it, the second most common response being to spend. However, my view is that as the recovery gains momentum and residual fears about potential unemployment fade, consumers are going to be willing to dip further and further into their savings. For this reason I have assumed that approximately 20% of savings will be spent over the coming years, a ratio in line with what was spent after the forced savings of the Second World War. To be fair to the Bank of England, they have also indicated that they see the potential for a further rise in the spending of accumulated savings as well.

I am also expecting a good deal of business investment over the next 24 months. Businesses started off 2020 with significant savings, driven in part by concerns over Brexit. However, with a deal now agreed, term planning can be resumed. Perhaps even more critically there are at least some signs of where businesses might productively invest post-pandemic. I can now predict with a bit of certainty that online retail sales will make up 30% of overall sales, up from 20% pre-pandemic; that working remotely which had been the norm for 14% of employees pre-pandemic and hit 38% at the height of the pandemic, is likely to move down to a more sustainable level in the mid 20’s; and that much of the economic pain which has been concentrated in a relatively few sectors is going to stop (benefitting restaurants, and anyone involved in entertainment), while persisting for a few (airlines).

And what about inflation?

The final question looming ever larger over markets is inflation. Recently I have set out the case for inflation over the next year or so being largely a temporary blip. This was based on three key factors: the base effect, todays inflation is being measured against depressed prices of a year ago; friction, the speed at which consumers start to spend may well overwhelm some businesses which put prices up as a result; and anchored inflationary expectations, people are not expecting or willing to tolerate inflation, thus they will seek alternatives if prices rise. Against this there are growing concerns about input prices, particularly commodities (although commodity prices, barring oil, have traditionally not been a significant enough part of end-product costs to trigger significant inflation) and most importantly the huge expansion of the monetary base, which although it has not lead to inflation over the past decade, could well do in future. Certainly this is something to watch as the economic expansion gathers pace.

James Sproule, UK Chief Economist

The global rates market was rather subdued throughout April, in line with the consolidation seen in the epicentre of it all, the US bond market. However in recent weeks we have seen the ascent in rates resume as attention turns back to fiscal policy in the US, coupled with growing inflation concerns. Albeit, the dismal US jobs report had dampened momentum a little (For more on the jobs report, see here Opens in a new window) but the bond market has since shaken this off.

More notable moves could be seen this side of the Atlantic though with volatility in bond and swap markets evident as the eurozone plays catch up in the vaccination race that has even sparked talk of a more hawkish European Central Bank come the summer (one for another Wrap). Last Wednesday’s US inflation figure (also see here Opens in a new window) gave bond sellers a bit more ammunition, 10 year US Treasury yields rose roughly 10bps to 1.7%, although again the move proved short-lived. Its German and UK counterparts have risen to -0.11% and 0.88% respectively.

A closer look at the UK rates market

Volatility in UK rates picked up prior to May’s Bank of England meeting with new forecasts and an expected tapering announcement (a slower pace of asset purchases under its quantitative easing program). More weight was definitely placed on the forecasts, as the tapering of weekly purchases (to £3.4bn a week from £4.4bn) allows for purchases to continue to run under the current envelope until the end of the year, which was the Bank’s intentions as highlighted in the November meeting.

Along with the upbeat forecast (see above in The economist’s corner) there was some excitement post-meeting as the decision was not unanimous, with outgoing chief economist, Andy Haldane, voting to actually reduce asset holdings by £50bn to £845bn. Swap rates across various tenors, or the curve as we refer to, jumped between 0.5bp-2bp post announcement – this doesn’t sound like a lot, but it is for a daily move! Nevertheless rates soon settled down to their pre-announcement levels. The 5-year Bank of England Base Rate swap rate sits at 0.55%, whilst its 10-year equivalent trades at 0.90%. Remember these rates have more than quadrupled since the start of the year, as traders rapidly re-price economic expectations for the UK, and globally, and therefore the outlook for inflation and the timing of the monetary policy response. There is no doubt as to the direction of where rates go from here, but the pace of the move is where opinions collide.

Game on: Markets vs Policymakers

You don’t have to look far to see this collision, just look at central bank rhetoric compared to market pricing. In the US, the Federal Reserve’s “dot plot” points to no change in rates until 2024, whereas the market sees one rate hike in December 2022 according to Eurodollar futures, a proxy for where the Fed Funds rate will be at that time. The same can be said in the UK, despite rosier expectations, the Bank of England continues to keep its monetary policy accommodative and has provided no concrete hints on the path for tightening (the central bank is currently reviewing previous policy of rates hikes coming before any balance sheet reduction), yet looking at the Overnight Index Swap (OIS) curve in the chart above, traders are betting on some movement in November 2022, with a 10bp hike. We on the desk will be watching the 2-year portion of the curve in the coming months, especially if the market appears to winning the battle. If there is more conviction in an earlier hike, perhaps of a larger magnitude too, we should see upward pressure on 2-year bond and swap rates. Only time will tell.

This ultimately will boil down to the continuing success of the vaccination programme, a smooth reopening of the remaining closed parts of the economy and most importantly the prospects of inflation. Incidentally, another proxy for UK inflation expectations, the 5Y 5Y forward inflation swap rate reached a decade high in April at 3.84%.

Hedging Interest

Interest in hedging is certainly picking up, as we draw attention to the re-pricing in rate expectations seen in 2021 so far. Interest rate caps are arguably proving more popular, despite the increasing price. With Bank of England Base Rate not expected to rise until the end of next year at the earliest, a cap allows borrowers to protect themselves at a designated level, but also benefit from lower market rates in the near term. A cap will compensate the borrower if the Bank of England Base Rate rises above the cap level. For those preferring swaps, or who cannot part with the cash required to pay for the cap, forward starting swaps may be an interesting option. A borrower can lock-in a fixed rate today, but to not take effect until a set date in the future, which then allows them to benefit from current low rates – as long as they have the confidence to remain unhedged over the given time frame.

Cameron Willard, Capital Markets