The period of extraordinarily low interest rates ushered in by the global financial crisis and extended during the pandemic may be about to draw to a close. The Bank of England raised rates in December 2021, February, March and May 2022, reversing a decade-long strategy. But what might this mean for your personal finances?
It is worth noting that, for the time being, rates remain relatively low, at 1%1. Even with inflation at a 40-year high of 9%2, there is still only a remote possibility of rates reverting to the highs of 5-6% seen prior to 2007. As such, any impact on borrowing, saving and investment is likely to be muted. The only real risk of rates heading back to these historic highs is if inflation does not start to moderate in the latter part of this year. This is possible, but central banks see it as an outside risk.
Higher interest rates should spell better news for savers with higher rates on savings accounts. In theory, this should diminish the jeopardy for cash savers, where the low rates on savings accounts left them vulnerable to inflation.
However, it is unlikely – in the short term – that interest rates will rise high enough to beat inflation. With inflation at its current levels, even if rates rise to 2% or 3%, holding long-term savings in cash could still be a risky option, diminishing the purchasing power of your savings.
Bonds have long lost their crown as the default option for those looking for an income from their investments. The income available on a UK 10-year gilt hasn’t risen above 2% - the Bank of England’s inflation target - since 20153. Against this backdrop, fixed income investment has been a poor option for those income investors who need to keep pace with inflation.
Higher interest rates may reverse this to some extent. Government bond yields have already started to move higher in anticipation of higher interest rates. However, again, the movement is relatively small in a long-term context. Gilt yields have moved from 0.2% in September 2020, to 1.9% today4. This is some way behind the 4-5% seen in the period to the financial crisis in 2007.
This suggests investors will still have to look to higher-risk investments, such as higher yielding bonds or dividends from the stock market, to deliver an above-inflation income stream that grows over time.
Mortgages and debt repayments
The more alarmist headlines about interest rate rises have focused on the impact on mortgage rates. Certainly, mortgage rates will go higher, but the relationship with interest rates isn’t linear. Mortgage rates depend on government bond yields rather than interest rates directly. They have already been rising and, as such, mortgage rates are already starting to reflect higher interest rates at the margin.
However, many investors will have pinned down long-term borrowing, fixing their rate for five or even 10 years. This means they won’t feel the full effect from interest rate rises initially. It may be that the interest rate cycle has changed again by the time they come to remortgage. This limits the impact.
It’s not just mortgage rates that will rise. The cost of personal loans, credit cards and other forms of borrowing will also go up. As this type of borrowing tends to be more expensive, the impact of rate rises may be incrementally smaller. The impact of credit card repayments rising from 20% to 21% is minimal, for example.
The stock market
Higher rates are not just a concern for those looking at cash and bonds. Interest rates also affect the valuation of shares. Part of the reason that technology companies have done so well in recent years is that the higher revenues they offer are more valuable at a time of lower interest rates. If a bond delivers 1-2%, a company that can deliver 50-100% growth is very valuable. If a bond delivers 5%, that company is a little less valuable. This explains the sell-off for some of the highest-growth companies in recent months.
In contrast, it may be good for sectors such as financials. Banks, for example, tend to do better at times of higher interest rates. Insurance companies have also tended to see a positive relationship with rate increases.
In general, higher rates are designed to dampen economic activity while lower rates are likely to encourage it. In reality, moving rates a fraction of a percent higher is unlikely to have a significant impact. However, if there was an inflation shock and central banks were forced to raise rates significantly to curb inflation, it could significantly hurt economic activity.
Whether consumer spending strengthens or weakens often depends on why interest rates are rising. A backdrop of higher borrowing costs (and therefore higher mortgages and debt repayments) is generally not good for consumer spending. However, if rates are rising because the central banks believe the economy is strong, it often goes hand in hand with higher employment, higher house prices and faster economic growth, all of which may be good for consumer spending.
For the time being, there is no reason to panic over higher interest rates. They are likely to move up slowly and the impact is expected to be relatively small. The real risk is if central banks move too slowly and inflation takes hold. Relatively few are expecting this to happen, but it would be a major jolt to financial markets if it did.
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- https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp, Bank of England, May 2022
- https://www.bbc.co.uk/news/business-61483175, BBC, May 2022
- Inflation and price indices, ONS, October 2021
- UK 10-year gilt, MarketWatch.com, October 2021
This article is based on our opinions which may change. It is not intended to constitute advice or a recommendation, and you should not take any investment decision based on its content
This article was previously published on Tilney prior to the launch of Evelyn Partners.