Blog Posts — July 23, 2018

How to prepare for a ‘no-hike’ scenario

by Christoph Schon, CFA, CIPM

Financial markets seem to consider a Bank of England (BoE) rate hike next month a foregone conclusion. Despite the fact that inflation for June came in lower than expected (2.4% compared with a consensus forecast of 2.6%), short-term interest futures still imply a probability of around 85% for a 0.25% base rate increase at the next Monetary Policy Committee (MPC) meeting on Aug. 2. While recent cross-asset class correlations clearly indicate that UK investors are concerned about political risk, this does not appear to notably affect their interest-rate expectations. Yet, BoE Governor Mark Carney has frequently voiced concerns about the uncertainty surrounding the Brexit negotiations and the constant turmoil within Theresa May’s government. So, any significant deterioration on that front could induce UK rate setters to stay their hands for yet a while longer, especially with inflationary pressures abating. We therefore encourage investors to prepare for a ‘no-hike’ scenario by performing some simple and straightforward stress tests.

As a starting point, we propose a historical scenario analysis, using the factor movements from the 4 weeks leading up to the Bank of England meeting on May 10. Similar to the current situation, a rate hike had been considered a done deal at the time—at least until the end of April. But the release of weak GDP and manufacturing data, combined with slackening consumer price growth, led markets to completely discount any base rate change by the time the actual decision was announced.

This period of repricing is highlighted in the two graphs below, which show the 2-year Gilt yield, the GBP/USD exchange rate and the FTSE 100 since the beginning of April. Both charts illustrate the close interrelations of these asset classes in the stressed environment. The pound in particular has been very closely linked to short-term interest rates, not only during that time, but also in recent weeks. The stock market also moved almost in lockstep with the exchange rate (note that the latter is on an inverted scale in the right-hand graph) in April and May—a pattern that had been very persistent since the EU referendum in June 2016.

Lately, share price and exchange-rate movements seem to have decoupled a bit, though. We therefore recommend an additional stress test using more recent correlations. As the August rate hike is almost fully priced in, we suggest shocking the 2-year Gilt yield downward by 25 basis points and using correlations from the last 20 business days to populate the remaining pricing factors. The table below shows some sample results from the two proposed scenarios for a GBP-denominated multi-asset class portfolio, using the historical and transitive stress-testing capabilities of the Axioma Risk™ platform.

The historical scenario—not too surprisingly—largely reflects the actual market movements between April 12 and May 10. Global stock markets lost around 6-7%, while the pound depreciated almost 6% against the dollar. Bond performance, on the other hand, was a more mixed. While the short end of the Gilt curve profited from lower rates, long-term yields actually rose, resulting in losses for bonds with maturities greater than 10 years. Other regions also saw rates increase and bond prices decline.

Under the current correlation regime, sovereign bond performance seems to be more consistent, with rates falling across the board and return variations mostly due to duration differences. One notable exception is Italian government bonds, which experienced losses due to rising risk premia. The latter also affected corporate bonds, with investment-grade issues underperforming sovereigns and high-yield even exhibiting negative returns. The wider credit spreads were also in line with lower interest rates and the falling equity markets shown in the transitive scenario.

The fact that share prices go down while bond prices rise and foreign currencies appreciate against the pound signifies typical “flight-to-quality” behaviour, which is usually an indication that markets are focused on (geo-)political risk. However, the recent stock market gains during the pound’s latest decline to 10-month lows against the dollar, could be an early warning that correlations could be returning to the patterns observed in the run-up to the May MPC meeting. At least, this would be some silver lining for UK equity investors, even if the expected rate hike gets called off at the last minute.