Interactive Investor

Bond Watch: have we seen the last rate hike in America?

5th May 2023 08:58

by Sam Benstead from interactive investor

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Sam Benstead breaks down the latest news affecting bond investors.

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Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

Here’s what you need to know this week.

US interest rates rise 0.25 percentage points

Interest rates in America rose again – but possibly for the final time in this hiking cycle – after a 0.25 percentage point rise was announced this week.

This puts US interest rates at between 5% and 5.25%, up from near zero in March 2022, following 10 consecutive rate increases.

But Federal Reserve head Jerome Powell signalled that it could be the last increase before pausing.

Greg Wilensky, head of US fixed income at Janus Henderson, said: “The Federal Reserve softened its language on the potential for future rate hikes, by omitting a line from their previous statement which said the committee ‘anticipates that some additional policy firming may be appropriate.’”

However, Wilensky noted that Powell didn’t definitively shut the door on the potential for future hikes.

“Nonetheless, we think the most likely outcome following this meeting is that the Fed pauses here,” he adds.

European Central Bank follows the US

The European Central Bank (ECB) also increased interest rates by 0.25 percentage points this week, to 3.25%, but signalled that they are close to completing the rate-hiking cycle.

Anna Stupnytska, global macro economist at Fidelity International, noted that the policy statement had a dovish tone, and that policy tightening is having an effect.

Stupnytska reckons that the ECB has already tightened interest rates sufficiently to cause a recession, which means that it should be wary about increasing rates further.

She said: “Even without further acute stress in the banking system in Europe, tight credit conditions are here to stay, ultimately leading to credit contraction and recession. Renewed banking stress in the US adds another layer of uncertainty to the already complex outlook.

“We continue to stress that the ECB is very likely already in the policy mistake territory that would ultimately require a rapid course correction in coming months.”

Why UK public finances have ‘deteriorated significantly’

One of Britain’s preferred methods for borrowing money via bond issuance is causing Treasury officials a headache.

One quarter of UK government debt is issued in index-linked bonds whose interest payments are uplifted in line with inflation. This compares to 8% in the US and 5% in Germany, according to fund manager Janus Henderson. This means the cost of servicing its debt has shot up.

In 2021, the UK government spent £64 billion paying interest on its debts – £26 billion of this was on index-linked debt, already much higher than in recent years.

In 2022, the total bill soared to £106 billion, of which an astonishing £69 billion reflected the impact of inflation on index-linked borrowing. The sum is almost as much as the UK spent on education (£77 billion).

Janus Henderson calculates that in 2022 the UK spent twice as much of its GDP (4.3%) servicing debt as it did in 2019.

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