Merlin Weekly Macro: Dear Jeremy / Dear Andrew

The most recent round of New Year monetary policy statements from the principal reserve currency central banks went entirely predictably: no changes at all to official interest rates. US Fed Funds remain in their target range of 5.25-5.5%, the Bank of England Base Rate is at 5.25% and the European Central Bank’s Deposit Rate, 4.0%.

As for the narratives and interpreting the verbal smoke signals, while sticking to the story that the next move in US rates will most likely be downwards, the Fed is trying to discourage markets from believing that any change will happen in the first quarter of this year however much they are hoping for it. At the European Central Bank (ECB), following a very bland, circumspect let’s-say-nothing-that-anyone-can-put-their-finger-on statement, Christine Lagarde was put under pressure in the subsequent press conference about her clearly unauthorised prediction in her side interview with Bloomberg at Davos a couple of weeks ago that she expects eurozone interest rates to fall from the summer; to the question from a Bloomberg correspondent about that prediction, her reply was , “So the comments I made to your television channel, Bloomberg, I certainly stand by them. I’m not sure that I would exactly characterise them as you have, but I stand by what I have said, not what others have commented that I have said”. She is a politician to her fingertips. The Bank of England Monetary Policy Committee’s vote was split again: two members voted for a further rise in interest rates, one wanted a reduction (the first vote for a cut by an individual member since the pandemic) and the majority wanted no change. Of the three central bank heads, Governor Andrew Bailey was the one whose public natural inclination for tighter policy for longer remains prevalent, indicating that as late as Q1 2027 (the current limit to the horizon of BoE forecasts) UK Base Rates could still be as high as 3.25%.

While moderating their aggression of Q3 2023 when they drove bond yields down with gusto (the corollary of which was rising prices), markets are still pushing their own agendas of forcing the central banks to begin cutting rates sooner rather than later, and faster rather than slower. This remains a monetary show of strength between the markets as the providers of capital and the central banks who regulate the benchmark cost; each believes it has the upper hand in determining the policy trajectory and its pace. The reality is that who is right and who is wrong will ultimately be determined by the regular flow of reported inflation data proving the point, measured not only by its momentum but also where it sits in relation to the 2% inflation target common to all three central banks. And as we have said often before, it is not just about hitting 2% once, but creating an environment for medium-term price stability at that rate.

An exchange of letters

After every Bank of England monetary policy meeting in the UK, accompanying the published minutes there is an open exchange of letters between the Governor and the Chancellor: ‘Dear Jeremy’/’Dear Andrew’, chummy first name terms despite the correspondence being a formal requirement. The Governor offers a summary and context of the decision, to which the Chancellor responds; if three months subsequently UK inflation data has still missed the 2% target by more than a percentage point either way, the Governor must explain to the Chancellor exactly why.

Reading these letters on GOV.UK, the content is revealing not just about what is said, but as importantly about what is not referred to. Given the Bank’s mandate is specifically about inflation and the appropriate rate of interest with which to manage it by massaging consumer behaviour, not surprisingly that is what the subject matter focuses on. However, what is not mentioned is the amount of debt to which the interest rate is applied, or its affordability. The reason is simple: it is not directly the Bank’s responsibility; at the government level, how money is raised and spent and any imbalance between the two is directly the jurisdiction of the Chancellor. The government borrows from the markets through the issuance of bonds (Gilts), rather than directly from the Bank (though this line becomes undoubtedly blurred when in periods of quantitative easing, the Bank is subsequently buying those bonds from investors), but it is the markets which ultimately determine the cost of that debt, weighing the intermediate risks and the likelihood of the principal sum being repaid.

However, whatever the contrived vacuum in which this Andrew/Jeremy correspondence takes place, not talking about the elephant in the room does not make the elephant disappear. There is the risk that the debt rises to a tipping point at which the interest bill becomes a systemic problem (in a similar situation, the US has already reached that point where Congress has slammed the brakes on government spending as the government persistently breaches its authorised borrowing limits). One might have thought it was in the interests of both the Bank and the Treasury to avoid such a predicament. With £2.6 trillion of UK government debt and an annual interest bill which has more than doubled in four years from £45bn in 2019 to an estimated £95bn in the 2023/4 fiscal year, were “government interest” an official spending department, it would have a budget second only to healthcare.

Real interest rates are now doing the heavy lifting

When it comes to terminology, the correspondence focuses on nominal interest rates. But no less important are real interest rates when adjusted for inflation.

Positive real interest rates, hardly seen in the UK since the Global Financial Crisis of 2007 and the inception of ultra-loose monetary policy, have been a feature since October of last year when the inflation rate dipped below the Bank of England Base Rate. A boon for savers, at last those with interest-paying accounts (assuming your bank is that generous) have the opportunity to hold cash and protect it from the ravages of inflation and to prevent its purchasing power being constantly eroded. Borrowers, on the other hand, having had the tailwind of the possible cost of borrowing being below the rate of inflation have also had the benefit of inflation reducing the real value of their loan (known in the trade as “inflating away the debt”); they are now in the reverse position with a positive real cost to servicing their debt making the loan more expensive.

Economists talk about the ‘stimulatory’ effect of interest rates in the way they can change economic behaviour, applying the brakes when rates rise and advancing the throttle when rates fall. But that is the point: using the analogy of an interest rate change being like a cattle prod, the beast only changes direction when it is poked with the stick. But leave the stick resting in contact with the beast’s back and nothing happens: there is no stimulus. Much the same happens with consumers and interest rates: even if the empirical evidence is that there is a delay, eventually there is a measurable response to the stimulus; but let the interest rate stay unchanged for a prolonged period, it simply becomes normative (the evidence of economic growth rates for the bulk of the decade up to the pandemic proves the point: virtually zero interest rates, indeed negative ones in the eurozone, were described as ‘stimulatory’ but towards the end, any beneficial effect on growth had evaporated).

Arguably, while keeping the nominal interest rate stable, the central banks are now playing a more subtle game on the path to achieving medium term price stability in line with that common 2% inflation target. As inflation gradually falls, even if the nominal rate of interest is constant and at a peak or a plateau as has been the case for several months, it is rising real interest rates which are now providing that stimulatory effect, encouraging depositors to save and borrowers to focus on minimising their debt burden. It is a game of subtle manipulation!

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.