In the November 2013 issue of The Treasurer (see page 36), we examine the complex relationship between interest rates and inflation. In this web-exclusive article, we also look at the potentially important implications for companies when dealing with cross-currency transactions.
The evolution of UK interest rates and their components can be broadly split into three periods:
Post 1981, a sustained period of stability allowed easily observable annual rates for both nominal interest rates and inflation (as shown in the graph above), which enabled the development of a pricing framework to measure the forward expectations of interest rates.
Perhaps it is no coincidence, therefore, that this post 1981 stability started with the introduction, by the UK government, of inflation-linked bonds (linkers). This new instrument linked capital growth directly to the path of current and future inflation, thereby creating a certain real return outcome for the bond(s).
The advent of a mechanism that allowed inflation-protected fixed returns encouraged longer-term foreign investment. This led to a positive cycle of economic benefits and allowed monetary policy to function more effectively, which, in turn, created stable correlations between interest rates and the resulting decline in inflation.
The containment of inflation allowed the development of markets for fixed real rates and derived real forwards. It also encouraged a parallel process that attempted to create sensible forecasts of inflation, which had previously been unfeasible. These resulting inflation forecasts, in combination with the established real rate forwards, gave a framework for nominal rate forwards from which fixed rates were derived. It should be noted that this whole process is vulnerable to a number of assumptions, interactions and correlations.
Until the financial crisis occurred, the trends appeared to be stable. So it was assumed that these relationships would continue and that the risks of the various components moderately diverging could be adequately modelled. Out of this, an insurance premium was calculated in order to create the certainty of fixed rates, which compensated for these ‘containable’ mismatch risks.
In order for forward interest rates to represent actual outcomes, they should – in theory – gravitate over time towards the short-, medium- and long-term expectations of those economic models. This relationship is especially important given that such forward expectations drive the pricing of fixed rates, which has the potential to influence the economic cycle.
Now that we have explored the historical context, it is important to illustrate some of the effects of these changing influences. In order to do this, we have used the Bank of England’s comprehensive database to determine if there are any observable pricing patterns.
We have presented the data in two main ways:
Using the historical data to measure the predictive accuracy of interest rate forwards, it can be observed that there is a movement away from the expected neutrality. This is especially compelling when the data are weighted by the level of interest rates over the prediction period (see the graph below).
Using the basic snapshot data from the Bank of England’s instantaneous forward curves (see the diagram below), we are able to compile a further set of forward rate graphs over important periods in history. It is essential to have such a detailed framework to be able to build an understanding of any readjustment process that has taken place that is particularly relevant when relating the outcomes to forward guidance.
So, how does the Bank of England view the current influences?
The following are the opening remarks by the Bank of England governor at the inflation report press conference on 7 August 2013. They are a useful summary of how inflation and interest rate relationships effectively detached after the crisis in 2007/8.
“Inflation is expected to fall back to the 2% target only a little after the two-year horizon. For that reason, the MPC’s [Monetary Policy Committee’s] judgement is that the path of market interest rates implies a faster withdrawal of monetary stimulus than appears likely given the current economic outlook. Above-target inflation, coupled with a depressed level of output, make for an exceptionally challenging environment in which to set monetary policy.”
All models, especially the economic ones, needed drastic updating from the long period of relative stability. This is illustrated by quoting Bank of England chief economist Spencer Dale, who said in October: “If the financial markets are pricing in a sharp rise because they think in the past every time the economy’s growing quickly the bank’s raised interest rates, I think they should think again.”
Good indicators of the application (and potential unwinding) of quantitative easing (QE) are the real rate forwards. The interaction between inflation and interest rates from the Bank of England data are shown in the next summary graph below (the shorter maturities are generated by interpolation with short-term spot rates).
The extreme combination of inflation, interest rates and economic uncertainty – not seen since before 1981 – has been a major test for those creating new fixed rates during this recent phase. Turmoil, particularly in real rate forwards, appears to have impacted pricing. It is potentially this effect that has been highlighted by forward guidance from central banks.
Having outlined the historical context and explored some of the current influences, we revisit the questions that we pose in our magazine article:
The Bank of England continues to suggest that market expectations are too high with regard to future interest rate rises. The fixed rates, from which these unrealistic high nominal forward rates are derived, may well contain a modified insurance premium. This can be explained as compensation against the markets reverting to a historical norm. Clearly the Bank of England is challenging this reversion, with Spencer Dale saying: “Our forward guidance says clearly that’s not the case.”
This potential modified insurance premium is illustrated in the graph below. The dotted line indicates nominal base rates based off forward guidance (ie ‘lower for longer’) mapped against the current market implied path. If forward guidance is correct, then the scenario in the right-hand diagram could hold.
Unfortunately, QE has introduced a new range of possibilities to overlay upon previous considerations.
The effectiveness of interest and/or real rate hedging needs careful review, especially when there may be ‘optical illusions’. For example, in the current upward sloping spot curves short-term forwards are relatively low, and as they are in close proximity to the floating rate, they are less likely to diverge from them – these lower rates are ‘blended’ with the higher forwards to give the overall impression of low rates.
From an absolute measure the modified insurance premiums may seem comparatively modest, but clearly they are significant enough to attract the attention of central banks. The relative magnitude has already been demonstrated in the predicted accuracy of forwards over time (weighted) graph above.
In addition, single currency-related hedging products based upon fixed rates should be reviewed carefully. If we include fixed rates across currencies, we need to appreciate that economies may be at different stages and require differing policy responses. If this translates into differing modified insurance premiums, this has the prospect of heavily influencing the effectiveness of FX instruments/hedging.
Although there is no historical precedent (because of the multitude and unique composition of factors contributing to the financial crisis), it is still possible to understand how some of these individual factors behaved in previous market shocks and interpret how this may impact the future. The most effective response is to creatively capture, as we have done, the magnitude of the various components and their interactions under those many situations in a model. Potential outcomes are therefore more quantifiable.
Based on our findings, it would appear that current pricing behaviour is still being modelled on the basis of historical precedents that are no longer conclusive and include assumptions that are not appropriate for determining current pricing.
Today’s treasurer is inundated with information from a variety of sources. It is therefore important to seek independent analytics that are able to filter out the ‘noise’ so that informed choices can be made with regard to future interest rates and inflation.
Forward guidance as a tool for the central banks is not only important for relative value analysis of nominal and real interest rates, it clearly also has significant implications for cross-currency exposures.
Will Haiser is inflation, rates and cross-currency consultant at Pegasus Capital LLP. He can be contacted at: wh@pegcap.co.uk