7726 tough talking and kid gloves itemid 127

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Tough Talking And Kid Gloves

Written by Paul Amery

  
February 16, 2011 13:34 (CET)

With the Bank of England talking tough on inflation, should investors buy an ETF that benefits from rate rises?

Mervyn King, governor of the UK central bank, is talking of interest rate rises again, and not before time.

With UK retail price inflation rising at 5% a year, the narrower consumer price index up 4% and the Bank of England in breach of its 2% inflation target for nearly three years, it’s now a matter not of whether rates will rise but by how much and when.

At the same time, King is walking a tightrope. Zero interest rates are clearly inappropriate for current levels of inflation, and if the bank were to hike them to give investors a positive real return, the base rate could well be at 6% or 7%.

But with most UK homeowners’ mortgage rates linked to the short-term wholesale interest rate, such a rise would send the UK property sector into deep depression.

King has talked tough before and failed to deliver, most notably in late 2007 when he said it was inappropriate for the government to bail out banks, then had to make a swift U-turn when Northern Rock got into trouble. Three years-plus later, the concept of non-intervention has gone out the window and the taxpayer is saddled with hundreds of billions of new liabilities.

But assuming he does what he says he’s going to, what’s in store?

The short sterling futures contract that’s traded on NYSE Euronext tells us what traders are anticipating for UK three-month LIBOR rates. This morning, short sterling discounts a rise in LIBOR from the current 0.8% to 1.65% by the end of this year, 2.85% by end-2012, 3.7% by end-2013 and 4.3% by the end-2014.

That’s a steady path for implied interest rate rises, but it’s not a particularly aggressive pace of tightening, bearing in mind where inflation is already.

It’s also obvious that central bankers are happy to deliver unannounced interest rate cuts when markets get into trouble, but that they are very reluctant to lead the market’s expectations in the other direction when rate rises are called for. There’s an inbuilt easing (inflationary) bias in the system, in other word, but that’s not news for most of us.

Summarising, the Bank of England seems very unlikely to push rate rises at a pace faster than that which is already discounted by the markets.

The db x-trackers UK Gilts Short Daily ETF allows investors to benefit from rises in interest rates, as expressed by gilt market yields. But since it was launched in May last year, there hasn’t been a clear trend in the fund’s price.

From May to September the fund fell in price as markets moved to anticipate the next round of quantitative easing. Since then bond yields have risen and the ETF has done better for its investors.

Bearing in mind the Bank of England’s previous form in promising tough action and delivering policy with kid gloves on, I don’t expect that much upside in this ETF from here (I don’t own it, by the way). As a saver suffering from a near-zero return on my cash, maybe I’ll be pleasantly surprised and rates will rise soon. But I’m not holding my breath.

 

 




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