Who You Gonna Call: Truss-Busters

By Martyn Page, Investment Director, Worldwide Financial Planning

November 3, 2022

MONETARY policy and belts were both a little tighter this week after the Bank of England raised its base rate from 2.25 per cent to three per cent, as expected. Before the announcement today (Thursday, November 3),markets had priced in an interest rate peak of 5.25 per cent. But, by mid-afternoon, that expectation had reduced to 4.65 per cent for next September.

We expect newspapers to focus on all the bad news: it was the largest single rate increase in a third of a century. We are already in a two-year recession. And with two million fixed-term mortgage deals set to expire by next Christmas, the average borrower of £130,000 could need to find an extra £3000 a year. Tabloids will say leaked plans to tax snowmen will hit the North worse than the South.

But the good news – and there is good news – is that Bank thinks the worst may be over. And it is saying so loud and clear. Even better, government bond markets – which set the wholesale price of mortgages – are listening.

For anyone with a mortgage, Halloween came early this year. The first scary moment came when the former chancellor announced huge unfunded tax cuts. This triggered a massive spike in the UK’s borrowing costs and led banks to pull existing mortgage offers, replacing them with frankly unaffordable ones. The second scary moment jumped out from behind some pension funds. These were caught short and temporarily pushed the cost of borrowing even higher in a brief but destabilizing downwards spiral. The Bank of England stepped in with its proton pack, diffused the situation and wholesale borrowing rates declined.

Next, the Truss-busters proton stream ray gun was turned on the chancellor, his policies and his boss. All were safely neutralised and replaced with a Sunak-safe pair of hands. Truncating the energy support scheme meant the Bank of England was less likely to raise rates as much and further dampened the spike in borrowing costs. In time, this should lead to better mortgage deals. 

The Bank of England regularly releases charts of where bond markets think interest rates might be in a year or so. These guesses are often wrong. So much so that in late October the deputy governor of the Bank did something highly unusual. Tucked away in a speech he inserted a chart saying that while the market was pricing in a peak of 5.25%, the Bank’s own estimates suggested this could perhaps be a whopping two per cent too high. 

Even if this is not precisely correct it suggests the Bank thinks there is headroom for bond yields to come down even as it raises base rates. If the deputy governor is right, this means that those with mortgages might not have to suffer as much as they currently believe. How long do we need to wait? Well, that depends on bond markets.

Markets do not know the scale of tax rises and spending cuts in the new chancellor’s Autumn Statement on November 17. But you can bet the Bank of England’s governor has been briefed. This latest expected rate rise was therefore interesting because two of the nine members who set rates voted for smaller increases. Those two clearly think earlier rate rises will do most of the job from now on.

The Bank was also unusually explicit for a central bank in saying where it thought interest rates might peak. And, unlike the US central bank, markets can still trust what Bank of England members say.

Quite remarkably, the Bank said it thought interest rates wouldn’t have to go up as much as currently priced into markets. Anyone needing a new mortgage deal should pay attention. We think it could be worth waiting a few months for market rates to fall and more attractive mortgage deals to emerge. Please do not feel panicked into grabbing any current ‘deals’ for fear of worse to come.

This does not mean that rates aren’t going to go up a bit more. Although that would affect those with variable rate /tracker mortgages, longer-term fixed rate deals could actually come down even if short-term rates rise a tad.

And it might just be a tad or two. The Bank spelled out that if interest rates did reach the 5.25 per cent indicated by markets then this would likely cause the longest recession since World War II with inflation hitting zero by 2025. The implicit message from the Bank to the markets is that we think you are over-estimating interest rates because we are not going to let such a scenario develop.

Interestingly, the Bank also forecast that if interest rates remained unchanged at three per cent although the economy might face five quarters of recession due to higher mortgage and energy costs, the inflation rate would be around its two per cent target at the end of the standard two-year forecasting window and substantially lower at the end of the third year. The risk to this outlook would be that large companies continue to profiteer, and consumers are persistent in pushing for further wage rises. This is the classic wage-price spiral whereby inflation becomes harder to deal with than Japanese knotweed. A recession and consumer belt-tightening make such a scenario less likely.

A final bit of good news arose from the fact that the Bank made its forecasts without taking into account the contents of the coming Autumn Statement - assuming the current government remains in place long enough to make it. The inevitable spending cuts and tax rises will clearly put downward pressure on inflation. Nor do we yet know the scope of the post-April scheme to contain energy costs. The Bank said that while a revised Energy Price Guarantee would dampen the energy component of inflation, if consumers felt flush their spending might still boost inflation in goods and services. 

Covid and various support measures have created a tight labour market. That means the Bank can’t easily lower inflation by raising the unemployment rate because this path would require setting interest rates much higher than the economy could bear. Remember, Putin apart, much of the inflation has been caused by companies pushing through price rises with a wily ‘It’s the cost-of-living crisis, innit’. 

So, rather than using interest rate policy to create unemployment, we think the focus should be on reining in consumer spending and pay demands – in order to squeeze company profit margins. This may come sooner than expected. The fanatical desire of many Brits to go on holiday means they have already pulled forward a lot of their spending. The ghost of Christmas Present may soon be visiting many households and haunting them awhile but in our view the ghost of Christmas Future can be avoided.

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