Interest rates: playing with the grown-ups 

They’re all at it. The European Central Bank (ECB) and the Bank of England have left the Middle School and have matriculated to the Lower Sixth, joined the Senior Common Room with the US Federal Reserve (Fed). All are now employing three-quarter percentage point rises in interest rates in their effort to deal with inflation. Starting from different points and dates, the lie of the land is now as follows: US Fed Funds target rate, 3.75-4.0%; Bank of England Base Rate, 3.0%; ECB Deposit Facility Rate, 1.5%. Those differentials, ‘spreads’ in market speak, alongside relative economic prospects, tell you virtually all you need to know as to why the US dollar remains strong against other major currencies: foreign exchange investors chase the three ‘M’s: Money, Momentum and Margin.

 

But if interest rates are rising now by identical increments in those three jurisdictions, at least temporarily, there the similarity largely ends.

The Fed and the Bank of England: differential future aggression  

In a feast of mixed and contradictory messages about inflation mileposts, the Fed seems committed still to a policy of shrinking its balance sheet and aggressively ramping up future interest rates, albeit next year more likely at a less gung-ho pace (i.e. probably by a half-point at a time) but for much longer than markets thought, in its determination to re-bottle the inflation genie.

 

In something approaching apocalyptic language for a central bank, the Bank of England is clearly worried about the UK’s economic wheels dropping off; it sees unemployment possibly nearly doubling to 6.5% in a projected prolonged recession (the longest in a century) lasting into early 2024 for which it is pointing towards our domestic interest rate cycle being less aggressive than anticipated. The only bright spot is the couple of percentage points shaved off the projected inflation peak, now at 11%, thanks to what remains of Liz Truss’s policy to limit consumer electricity and gas prices.

 

Crudely, if one were to summarise the two Anglo-Saxon approaches, the Fed is still charging round swinging an economic baseball bat with little regard for whoever gets in the way; on the other hand, one senses a reluctant Bank of England has felt coerced to join the same game but would be much more inclined to be playing softball as its preferred pastime and left to its own devices 

The ECB on the other hand: if you can make sense of this… 

Finally, while simultaneously juggling balls and attempting to keep so many technical spinning plates aloft, the European Central Bank is in a fog of its own. Fathom this, if you can: with its one-size-fits-all policy it is raising interest rates uniformly across the 19 eurozone states regardless of the vast disparity between national inflation rates, ranging from 6.2% in France to over 20% in each of the Baltic States; unlike the Fed and the Bank of England which are actively selling bonds back to the market to reduce their balance sheets, the ECB continues to refinance its member states’ national bonds when they reach maturity and redemption.

 

The ECB remains worried about the financial risk of creaking banking systems and wobbly economies potentially falling over under the weight of funding their own debt as interest rates and bond yields rise, notably Italy and Greece (and to a lesser extent the other ‘Club Med’ countries); in an effort to contain systemic risk and financial contagion (it really does not want to repeat the Greek crisis of a decade ago), its Transmission Protection Instrument hastily introduced under emergency conditions in July involves essentially reversing quantitative easing (QE) for the fiscally stronger countries (Germany, Austria, Finland etc) and reducing the ECB’s ownership of those countries’ national bonds, while actively buying the bonds of the economically vulnerable nations. The idea is to limit the spread against the German 10-Year bond yield to no more than 2.5 percentage points (currently for Greece and Italy the spreads are 2.39pts and 2.14pts respectively).

 

However much it denies it, by any other name this is crude yield curve management, ostensibly illegal under the ECB’s mandate. But whatever the legality or not (and ECB President Christine Lagarde has effectively thrown down the challenge to her detractors especially in Germany: until you have a better idea, best keep very quiet because if this all goes horribly wrong you, Germany, will be on the hook financially to pick up the pieces), economically for one group of countries she has both feet on the brake pedal simultaneously raising interest rates and withdrawing liquidity, while for the others (Italy, Greece etc), she has one foot on the brake (interest rates) and the other on the accelerator (the stimulus of bond purchasing). All clear? 

Policy pea soup   

Of course, it should be a case of ‘horses for courses’, each economy confronting its own circumstances. Markets use historic data as an anchor point of what has happened, a sense check and reference along the economic pathway. But their real interest is in what is coming next, at every step second-guessing the future direction of policy travel, whether by central banks or governments. There is no reason all central banks should be pursuing identical paths. Today’s situation is immensely complex. It is predicated on a decade-and-more’s diet of QE and ultra-loose monetary policy linked to prolific Keynesian liberal fiscal policy in which governments have become used to bingeing on cheap debt assumed to be on the never-never. That complexity was compounded by the inflationary effect of the significant dislocation created by a pandemic and a global geopolitical conflict whose military epicentre is in Ukraine.

 

For investors, the result is a policy pea-souper; it is hardly surprising that markets remain volatile while trying to navigate through it, especially when in so many cases there appears to be little joined-up thinking or strategic coordination between central banks’ monetary policy and their governments’ fiscal policy, let alone coordination between countries. 

Gnothi Seauton  

And speaking of what happens next, since our last publication a fortnight ago, exit stage right the second Prime Minister in three months, enter stage left the third this year and the fourth since 2019. There is little point raking over well documented old ground as to why Liz Truss’s tenure proved such a short-lived and catastrophic affair. “We face an economic crisis……mistakes were made”, shamelessly announced a portentous Rishi Sunak on his accession, without batting an eyelid. The hiatus in bond markets arising from Kwasi Kwarteng’s inappropriately named ‘mini budget’ which caused investors to take fright and required Bank of England intervention to stabilise the Gilt (UK government bond) market, was entirely the fault of Truss’s administration. Certainly it was a crisis. But it was almost entirely a financial one, the effect subsequently and quickly mitigated by Kwarteng’s summary dismissal and the appointment of Jeremy Hunt as Chancellor and the budget being 90% reversed before it was enacted.

 

So why do we say shameless in respect of Sunak? However much it suited him politically to lay the blame on his predecessor, to be completely clear (as politicians themselves are fond of saying ad nauseam), the economic crisis referred to by Sunak was not the fault of Liz Truss: it saw its roots sown and embedded mostly during his own period in Number 11 as Chancellor. The ancient Greeks had a saying, ‘gnothi seauton’: know thyself; Sunak’s lack of self-awareness is either alarming in his naivety or it shows immense arrogance. Time will tell which.

 

We await Hunt’s deferred Autumn Statement with interest; the challenges are indeed daunting, notably how to contain government deficits and reduce burgeoning borrowings at a time that the cost of funding that borrowing has been rising sharply and the economy is on the point of shrinking potentially for the longest period in a century. And a strategy for investing for future growth? In the UK at least, forget it: the markets have decided that economic repression is a price worth paying to balance the books now, economic growth can wait for another day. It is a policy tin can which has been kicked down many roads for more than a decade. After the drubbing the previous administration had at the hands of the markets last month, no sane Chancellor is going to take them on again. Meanwhile for investors and savers, the leaked plans to jack up the rates of capital gains tax and dividend and property rental income taxes are gloomy news indeed. A kite-flying exercise to test the reaction, as was the case in 2020? Or a political wheeze to steal Shadow Chancellor Rachel Reeves’ thunder by directly pinching her planned policy were Labour to be in office? Or merely warming us up to soften the blow when it lands on November 17th? We will know soon enough.

 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions. 

The value of active minds – independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Fund specific risks

The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.

Important information

This document is for informational purposes only and is not investment advice. We recommend you discuss any investment decisions with a financial adviser, particularly if you are unsure whether an investment is suitable. Jupiter is unable to provide investment advice. Past performance is no guide to the future. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.  The views expressed are those of the authors at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change.  This is particularly true during periods of rapidly changing market circumstances. For definitions please see the glossary at jupiteram.com. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Company examples are for illustrative purposes only and not a recommendation to buy or sell. Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ are authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of JUTM or JAM. 29577