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Tough times: Chancellor Jeremy Hunt
The markets are a bit depressed regarding interest rates. Late last year they were confident that falling inflation would pave the way for central banks to start cutting rates very soon, with the US Federal Reserve perhaps leading the way as early as March.
Other central banks, including the Bank of England, would follow suit. The debate revolved around how many cuts there would be this year: three, four or more.
This optimism fueled a rally in bond markets, causing the 10-year US Treasury yield to fall to 3.8 percent and sending the 10-year bond yield (UK government bonds) ) to less than 3.5 percent. This drop in the long-term cost of money was transmitted in many ways.
In the UK, we saw the prospect that lower debt charges would mean Jeremy Hunt would have more room for tax cuts in the budget on March 6, and a mortgage rate cut war. That led Barclays to offer 4.1 per cent for a two-year deal and Santander 3.89 per cent for five years.
Those deals were just announced, so I expect them to last a while, but last week the skies got a little darker. Perhaps inflation would not fall as quickly as expected. Perhaps central banks would have to delay their rate cuts. So the yield on 10-year US bonds has risen again to around 4 percent, and government bonds are around 3.8 percent.
It’s not panic, but rather the realization that the road back to somewhat cheaper money will be bumpy and difficult.
It’s easy to list the things that could go wrong. The conflict in the Red Sea increases shipping costs and will slow, perhaps reverse, the decline in inflation. It is necessary to finance the deficits of governments around the world. The pile of debt accumulated by central banks under quantitative easing has to be sold back to the public; From now on it is a quantitative adjustment.
Companies that have become accustomed to cheap debt are facing similar pressure as people who took out cheap mortgages that have now been refinanced.
We keep hearing the R word, recession, popping up in the US, Europe and the UK. Etc.
It is not necessary to believe in the deep sadness of the greats who attended the Davos forum this week to recognize that this will be a difficult year. We’ll hear a lot of that in the coming days.
But then – as in our real estate market – the dire forecasts continue to be too pessimistic. Smart people, or at least many of them, continue to be proven wrong.
What we have to recognize is that we are in the early stages of the transition from very low interest rates to normal rates.
For many people, it’s a new experience and it applies as much to market professionals as it does to the rest of us. Getting used to these new conditions will take at least a couple more years. We don’t know how to put a price on things.
This can be seen in the valuations of American high-tech giants. Microsoft briefly overtook Apple last week to become the world’s most valuable company. But are they really worth almost $3 trillion each? They are big companies, but their directors have a hard time justifying the fact that their market capitalizations are larger than those of all the companies in the FTSE100 index.
Now that investors can finally earn a reasonable return on bonds, they should surely play some role in balanced portfolios.
In fact, the main message I take away from these last few weeks is that you can’t get the timing right with bonds, any more than you can with stocks. Every now and then there is a period where the markets have clearly overreacted. The Footsie’s fall from 7,400 before the Russian invasion of Ukraine in February 2022 to below 5,200 four weeks later was a case in point. But most of the time there is a reasonable balance between optimists and pessimists and the bumps we are seeing now in bond markets are the new normal.
The message from this to Hunt is that he may have more room for maneuver in the budget than he expected when he made his Autumn Statement in November, but he shouldn’t expect it to be huge.
And the message to anyone needing to renew a mortgage is that if you can borrow five years for less than 4 percent, you’ll get the money almost as cheap as Hunt. Her credit is almost as good as that of Her Majesty’s Government.
This should be a modest consolation in these difficult times.