HAMISH MCRAE: We are on a bumpy path to cheap money

Updated: 09:08 BST, 16 January 2024

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Tricky times: Chancellor Jeremy Hunt

The markets are in a bit of a funk about interest rates. At the end of last year they were confident that falling inflation would clear the path for central banks to start cutting rates pretty soon, with the US Federal Reserve leading the way maybe as early as March.

Other central banks, including the Bank of England, would duly follow. The debate was about how many cuts there would be this year – three, four or more.

This optimism fuelled a rally in the bond markets, driving the ten-year US treasury yield down to 3.8 per cent and sending the yield on ten-year gilts – UK Government bonds – to less than 3.5 per cent. This fall in the cost of long-term money fed through in all sorts of ways.

In the UK, we saw the prospect that lower debt charges would mean Jeremy Hunt had more room for tax cuts in the budget on March 6, and a rate-cutting war in mortgage rates. That led to Barclays offering 4.1 per cent for a two-year fix and Santander 3.89 per cent for a five-year one.

Those deals have only just been announced, so I expect will be around for a bit, but last week the skies darkened a little. Maybe inflation would not fall as fast as hoped. Maybe the central banks would have to delay their rate cuts. So that US ten-year yield has climbed back close to 4 per cent, and gilts are about 3.8 per cent.

It's not a panic, more a realisation that the path back to somewhat cheaper money will be a bumpy and difficult one.

It's easy to list the things that might go wrong. The conflict in the Red Sea adds to shipping costs and will slow, maybe reverse, the decline in inflation. The deficits of governments everywhere have to be financed. The pile of debt built up by the central banks under quantitative easing has to be sold back to the public; it is quantitative tightening from now on.

Companies that have become used to cheap debt are meeting a similar squeeze to people who took out cheap mortgages that now have be rolled over.

We keep hearing the R-word, recession, cropping up in the US, Europe and the UK. And so on.

You don't have to buy into the deep gloom of the grandees attending the Davos forum this week to acknowledge that this will be a difficult year. We will hear a lot of that in the next few days.

But then – rather like our housing market – the dire forecasts keep turning out to be overly pessimistic. The clever people, or at least too many of them, keep being proved wrong.

What we have to recognise is that we are in the early stages of the transition from very low interest rates to normal ones.

For many people, it is a new experience, and it applies to market professionals as well as the rest of us. Getting used to these new conditions will take a couple more years at least. We don't know how to price things.

You can see this being played out in the valuations put on the high-tech American giants. Microsoft briefly pipped Apple last week to become the world's most valuable company. But are they really worth nearly $3 trillion (£2.35 trillion) apiece? They are great companies, but it is asking an awful lot of their managements to justify the fact that their market capitalisations are greater than all the companies on the FTSE100 index.

Now that investors can at last get a reasonable return on bonds, they should surely play some part in balanced portfolios.

Indeed the main message I take from these past weeks is that you cannot get your timing right with bonds, just as you can't with equities. Every now and again there is a period when markets have clearly over-reacted. The plunge in the Footsie from 7,400 ahead of Russia's invasion of Ukraine in February 2022 to below 5,200 four weeks later was an example of that. But most of the time there is a reasonable balance between optimists and pessimists and the bumps we are seeing now in the bond markets are the new normal.

The message for Hunt from this is that he may have more leeway in the Budget than he expected when he framed his Autumn Statement in November, but he should not expect it to be huge.

And the message for anyone who has to roll over a mortgage is that if they can borrow for five years for less than 4 per cent, they are getting the money almost as cheaply as Hunt. Their credit is almost as good as that of His Majesty's Government.

That should be a modest comfort in these tricky times.

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