29th Oct '23 by Edmund Shing

10 comments 1867 reads

Market Musings 291023: The One Rate to Rule Them All

Summary:

● Interest rates matter, a lot

● Long-term interest rates are even more important today

● Big increase in bond yields since July

● Competition for investors’ savings

● Direct economic impact of long-term rates

● Where next for long-term bond yields

● Economic contraction in Europe, but growth persists in the US

● Good chance that long-term bond yields fall

● Lower bond yields could herald a rally in markets

Podcast this week:

Podcast: The recent fall in stock markets

In today’s podcast, Edmund Shing analyses the recent corrections on the world stock markets:

· An ongoing stock market correction

· The drivers of this pullback in stock markets

· Solutions to diversify a portfolio in this context

Interest rates matter, a lot

Since the end of July, I believe that the one key factor driving stock, bond, and real estate markets have been interest rates.

Interest rates can be divided into two types:

· short-term, and

· long-term.

Short-term interest rates are typically decided by central banks such as the US Federal Reserve, the European Central Bank or the Bank of England. These rates are typically decided on as a function of the level of inflation and growth.

Remember that the central bank's target ultimately is to keep inflation over the medium term at or around 2%. You may of course ask why 2% is the target and to some extent it's arbitrary.

Nevertheless, the fact that central banks have an explicit inflation target of low inflation is important for ensuring economic stability over the medium term

So how exactly do the short-term interest rates work to determine inflation and growth?

The higher the short-term interest rates are, the higher the cost of borrowing is. But equally, the higher that savers are remunerated for keeping money in a savings account. So, there are winners and losers. Borrowers, of course, lose from higher interest rates, while savers gain.

What does this do? It raises the cost of financing of loans, particularly for consumers and, of course, for smaller businesses who depend more on loans from banks and loans which have a shorter payback period. The finance costs of these loans tend to be based on…

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Albm7

29th Oct '23

Great piece as always, thanks Edmund

BenHazz

Hi Edmund, really great article. Thanks for taking the time to post, as always, clear and interesting. By chunking down your explanations and adding examples and images it really helps simpletons such as myself to understand. I know it's a macro article but would be great to hear the individual companies you are favouring over the coming months, provided the rates do drop and we potentially (everything crossed) get a much overdue Santa rally.

scrooge

Edmund. Thanks for the article- thought provoking as always.

My worry on interest rates concerns the borrowing needs of the Public Sector. Existing needs to borrow new funds is not going to disappear any time soon (especially given the political timetable in the US and in Europe), conflicts existing or threatened around the globe suggest a big boost to military spend and likely downturn in economies will only cause those public deficits to balloon further. 'Printing' money is no longer an easy option. Higher for longer seems the likely course for long term interest rates too and thus the long overdue rally in markets is likely in my view to be delayed a while yet

Saxonboy57

30th Oct '23

Thanks Edmund. A really fascinating read

rpannell

I must confess to being one of the people selling equities and buying gilts. In my case, this is not driven so much by the current high rates on offer but due to the unequal tax treatment. I've kept all my ISA equities but outside of ISAs, it's hard to ignore the almost tax free gains currently available on low coupon gilts or on index linked gilts. A gilt giving 5% is equivalent to a taxed account at 9% to a 45% taxpayer. I've mainly gone for index-linked gilts which are offering around CPI + 1.5-1.8%, almost tax free.

Epitychia

Really good article. It touches on something i have been thinking about. Bond markets are larger than stock markets and bond markets have just had their largest crash in history. What is the impact of this loss on bond holders and the economy. Secondly the curious corollary is that governments have done very well by selling enormous amounts of debt at very low yields in past years. Although this has now stopped.

Glorenfeld

2nd Nov '23

Hi rpannel, I might have misunderstood your point, but I thought income on gilts was taxed as income, while capital gains were not taxed?

thegreyman10

11th Nov '23

you do pay tax on a capital gain but not if the face value of the gilt is lower than the sell price when you bought it at a depressed price and that the gilt chosen has a low coupon and you hold them to maturity

Eventually, at maturity, the bond will repay the original face value but you do not pay tax on the appreciation ro the settlement price (the original value the gilt was sold for) . Under those conditions then all you pay is any tax on the coupons you have received. Look at Gilt code TG35 - pays a tiny coupon and seriously under face value (this is not a recommendation but an example)

13th Nov '23

As the Greyman says, the secret is to go for a deeply discounted gilt such as his quoted TG35. This has a coupon of .625% and is currently priced at 65.21. The yearly interest is .625*100/65.21 = .96%. This is taxed at your normal income tax rate. In 11 years and 9 months time, the gilt will mature at 100 giving a gain of 100-65.21 = 34.79 per gilt or a compound gain of 3.7% py, untaxed.

So, as a higher rate taxpayer, go for deeply discounted gilts with the lowest coupon, where most of the return is in the uplift at maturity. Such gilts are TN28 (1/8% coupon) or TG31 (1/4% coupon). Alternatively, the index linked gilts are usually on a 1/8% coupon.
No investment advice intended or given.

Market Musings 291023: The One Rate to Rule Them All

Market Musings 291023: The One Rate to Rule Them All

Summary:

Podcast this week:

Podcast: The recent fall in stock markets

Interest rates matter, a lot

So how exactly do the short-term interest rates work to determine inflation and growth?

Unlock the rest of this article with a 14 day trial

About the Author

Edmund Shing

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