A few weeks ago I said that the key story in 2011 is going to be interest rates. Rates up – everything else down… stocks, bonds, and commodities – everything!
And for the last week the press has gorged themselves on rising rates stories. Inflation hit 3.7% in December. And the pundits are up in arms about our inflation problem and the need for higher rates to contain it.
“It’s plain as a pikestaff that interest rates need to rise to cool inflation,” said Jeremy Warner in the Telegraph.
But it’s not going to happen. The truth is that the Bank of England can’t raise interest rates now – the Governor’s hands are tied.
But someone else can. A group even more powerful than The Bank of England. And we need to keep a close eye on them over the next few months…
Why the Governor’s hands are tied
Yesterday afternoon the markets were treated to a shock. The economy, the Office of National Statistics revealed, contracted by 0.5% over the last quarter of 2010 – sending the markets into a tumble.
Now it probably didn’t take you by surprise. But the point is that this shock will ensure the Bank of England does nothing to lift interest rates.
The problem for the UK is that without low rates the economy could go into freefall. That’s why Governor King cut so much more aggressively than the ECB at the height of the crisis in 2008.
We have over-borrowed homeowners, banks, property funds and businesses up to their eyeballs in debt. Raising rates now could crush the economy and ultimately weaken the pound.
The Bank also recognises that lifting rates will probably do nothing to counter inflation. What you’ve got to remember is that the things inflating are the very things that we can’t control. Britain no longer rules the waves and she’s not large enough to influence the markets that really matter.
I mean, will OPEC pump more oil, or the Indonesian clothing magnate bring his prices down just because Mervyn King raises rates? Of course they won’t – and that’s why the Bank is going to continue to ignore all of those pleas for higher rates.
And if raising rates is supposed to help the pound, then think again. Crushing the economy is hardly going to be conducive to foreign investment.
Ultimately, the way the Bank sees it, raising rates will bring on the ‘day of reckoning’. And there’s no will to do that. Modern Central bank banking is all about kicking the can further down the road. ‘This economy’s not going down the tubes… not on my watch.’
But what if the market takes away interest rate policy from the Bank? Well this is the scary scenario that we now face…
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This could get very ugly!
Let’s go back to Black Wednesday – September 1992. Norman Lamont, the treasury and the Bank of England were determined to maintain the value of the pound (as it had to trade within the ERM band). They fought tooth and nail both buying sterling in the market and raising interest rates…
And I ask you. Did that nice little economic theory about raising rates, cause the pound to strengthen? Not in the slightest! It showed desperation. And the pound got trashed.
Now we may be in a different situation this time, but the principle is the same. If the bond market decides it wants interest rates on the pound higher, it’ll get its way.
One way or another, I’m gonna find ya’, I’m gonna get ya’, get ya’, get ya’, get ya’
Blondie, One way or another, 1978
One way or another, rates go up.
If the politicos do nothing to take charge of the situation, it will be left to the market to take charge.
It could happen this year, maybe next, or maybe even the one after that… and if it’s left to the market to make its move, it’s not going to be pretty. If UK bonds sell off, it’ll drive yields higher – market interest rates go up.
That’s why we need to keep a close eye on the yield curve – which maps out interests for bonds over the next five, ten, twenty years….
If we see a shift in the yield curve – say the yield on 10-year gilts suddenly jumps 100 basis points – it’ll be time to wind down exposure to the markets. In a big way.
So ignore the press and keep your eye out on that darned yield curve. Here’s the link to the FT’s gilt yield curve… I recommend you bookmark it straight away.
Of course I’ll keep you up-to-date too; this is the most important chart for 2011 after all. And I’ll keep you posted on how we’ll prepare for the market’s attack in forthcoming issues of Right Side.
• This article was first published in the free
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