173. Why it takes 18 months for interest rate rises to have an impact

17 February 2022 (pre-recorded 15 February 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast. This week Darius sits down with the Richard Woolnough, manager of Elite Rated M&G Optimal Income, as well as M&G Corporate Bond and M&G Strategic Corporate Bond funds, to discuss inflation and interest rate rises in depth and what it means for bonds.

Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. I’m absolutely delighted to be joined by one of the most high-profile fixed income managers, Richard Woolnough, who manages a number of Elite Rated funds. Richard, good morning, how are you?

Richard Woolnough (RW): Morning Darius.

[INTERVIEW]

[0:38]

DM: So, look, fixed income, we have to start with the macro and the macro today is dominated by inflation and interest rates. So, in the UK we’ve had a couple of rate rises in the last few months, which some may have thought were a surprise, some may have thought were a little bit late. US also looks [like] it’s going to be heading to rate rises sooner rather than later and probably more than we thought a year ago. Let’s start there. What’s your view on inflation and where do you see that taking interest rates in the next 6 to 12 months?

RW: Ok. Well there’s always, the forefront of our minds is where interest rates are going to be. Being a bond investor, we focus on where long-term interest rates are going to be. But obviously all the short-term interest rates, when you add them up over time gives you the average long term interest rates. And they set the tone and the cost of money. And if short rates are very high, it tends to mean that long term interest rates are high. And if short rates are very low, it tends to mean that long term interest rates tend to follow that trend. So, it’s a suitable place to start. 

The question is: why do they use interest rates? And why are they moving these interest rates? Interest rates get moved around in order to either encourage consumption: they are very low, so therefore you borrow and you consume. Or are they are very high, which means that you do not want to borrow and consume, you want to save. And this is the methodology that interest rates work. When interest rates are near zero, obviously it’s lovely to you know, biases you towards borrowing. When interest rates are very high, you obviously cut your cloth accordingly and don’t get involved. This is the ‘transmission mechanism’. This is what the Bank of England wants to do. This is why they set interest rates, why they’re independent and it’s their purpose. When the economy is very weak, they obviously cut interest rates to increase consumption and reduce savings. And when the economy is very strong, they put interest rates up to discourage animal spirits to make us more conservative in our behaviour and save as opposed to consume. 

The question is, you know, how does that policy work? And I think your preface was quite accurate in terms of, is it surprising? Is it late? And we’ll spend some time talking about that as we go through the conversation.

DM: Yeah. 

RW: But it takes 18 months to 24 months for policy to work. Should we spend some time talking about that?

[3:23]

DM: Yeah. I think that’s really interesting. That’s sort of a lag effect. I’m surprised it’s that long. I think that’s really interesting. Yeah, lets talk a bit more about that. 

RW: Well the… why we think it’s that long is because that’s what we empirically observe. When you look at the data monetary policy takes 18 months to 24 months to work. It takes a while. If they cut interest rates and you decide to go and buy yourself a house, you don’t buy it that day. You don’t move in that day. It takes you a while to buy a house. And then when you’ve bought the house, you then it takes you a while to refix it, bring your removal man, bring your lawyer in, you know, pay the estate agent, all these kind of things take a while – the transaction takes a long time. It’s a long lag.

DM: Yeah.

RW: And similarly you know with the economy, if it boosts the economy, people don’t immediately go and hire people when rates are cut, they don’t immediately go and fire people when rates are put up, it all works with a lag. 

Why do we say 18 months? It’s because empirically we’ve observed this around the world. You find that when interest rate policy gets changed, whether it be the US, Europe, UK… if it has a meaningful effect, it tends to lag 18 months. And that’s a very interesting sort of starting point maybe for the next part of the conversation. Is, you know, we have this high inflation now, we have full employment now, and the high inflation and full employment we have is in response to the very easy monetary policy we had 18 months ago.

DM: And that we had 18 months, two years ago, yeah. 

RW: So we’ve got high inflation. Why is that? Actually we’ve had the easiest monetary policy on record. We’ve been printing money, you know, we’ve got strong growth. So you can see in the real time as we sit here, why is the world booming? There’s obviously outside effects very different this time, in terms of obviously the public health response that’s gone on. But from a purely monetary perspective, you can see the inflation and strong growth we have now is the function of the monetary policy of the Bank of England. And the budget deficits we ran, you know, during the COVID period.

DM: So when we have this higher inflation on the lag from the money that were put into the system in the last 18, 24 months, and then we see interest rates going up, what does that mean for bonds? Cause my basic bonds 101, inflation = bad, rates going up = bad. Is that the case? And with that lagging effect, are we already partly through it, as the market looks forward to these rate rises or maybe look forward is the wrong terminology, but expects, expects these rate rises to come. What does that mean for my standard bonds?

RW: Well it’s a correlation between, as I said before, between short rates and long rates, it depends what happens. If you think that inflation is permanently going to be high and above 2%, that means the central bank will have to run a high interest rate, not for a week, a year, but for a number of years, which means the average long term interest rate will be very high. 

DM: Yeah, will go up. 

RW: If you think that just this move the Bank of England has done now is enough to kill inflation and we go back to a deflationary world, then obviously bonds are value because if inflation is low, then bonds are by default value. The central bank doesn’t have to put rates up to hit its 2% inflation target. So really it’s a view about inflation. Do you think that the central bank’s actions and the outside inflation world mean that this is a temporary, to take a central bank word, you know, blip in inflation, or do you think it’s something more permanent? 

The more permanent the inflation problem is, the longer and higher interest rates have to be. The less permanent the inflation problem is, the lower and the shorter the hike in rates has to be. Obviously, we invest for the long term. We look at long term interest rates and that’s what drives us. There is this strong correlation between the two. You have had periods before where, you know, interest rates have gone up and it’s had a big effect on long term bond markets and other times where they’ve gone up and it’s had a de minimis effect. It depends on whether you think it’s a temporary measure or whether it’s a permanent measure.

[7:30]

DM: And what’s your base case today then Richard, are you in the longer, higher for longer with rates because of inflation or are you in this sort of like camp where a number of people think that the peak of inflation is nearer rather than further away?

RW: I think it’s fair to say that I’m in the, the central banks are being very relaxed about creating inflation. It’s almost like a policy response: they don’t want inflation near zero because it means their policy response is – their armory, their toolkit – is de mnimis because it’s hard to get negative rates. So, they sort of want inflation. I think they’ve just been a bit surprised about how much it actually created. I think they’d be very happy if the number was three, four [percent] they’d be like, well, great, that isn’t a problem. But when the number six, seven [percent] their sort of their models aren’t working and they don’t quite understand it. So, they are very surprised by this. As, you know, many people are. And so, including myself, I’m surprised it’s got this high, I thought it could go high, but I’m surprised it could go this high. 

So the question is, what’s the Bank of England, what’s the ECB, what’s the Fed going to do? It depends on what they decide to be as their policy response. If they want to kill inflation, they can, but it means they have to be super aggressive. I don’t think there’s the economic or political will for them to be super hawish, mega hawks. A hawk is like an aggressive…

DM: A rate riser, yeah.

RW: I’d argue they’re move dovish, a term we use in the bond market, which is a bit more peaceful. And so I think they’re a bit more dovish and, as such, they’re going to be very slow in reacting and this slow reaction means that inflation will be higher for longer. If inflation’s higher for longer, then bond yields need to be higher for longer. 

Now, things will change that, you know, as the market changes, valuations change, we’ll change our opinion on the like of data on the economy or the data in terms of what we can buy and sell. But my view is that, they’re – to use an expression – they’re behind the curve, which is almost saying like you are just one step behind.

DM: Yeah. 

RW: The question is, are they one step behind, two steps behind or three steps behind? But they’re definitely behind.

[9:49]

DM: But I would think and again, I’ll take your view on this. There’s a certain consensus that we’re going to get a number of rate rises fairly quickly now. And we may even get larger rises, ie not just 25 basis points or 0.25%, but we may even see a half a percent in America in March. Is that your sort of view that they’ll go, having become behind curve, as you’ve explained, you know, they’re maybe a bit late to the party. Do you think there’ll now be some short aggressiveness on rate rises or that they will just have this slow and steady rising policy?

RW: I think as they’ve got a history of behaving in a steady and predictable manner, it’s not surprising given it’s a public policy. Public policy tends to be steady and progressive, it’s run by a committee, committees tend to be steady and progressive. So, you know, you’d expect it to be in a steady and progressive style because, you know, they stick… that’s the kind of committee and organisation they are, general speaking. 

DM: Yeah. 

RW: I think the Bank of England is a little bit different. I think the Bank of England, this sort can be quite independent. You know, they can think differently, which is probably why, you know, when you look around the world, they were the first to stop buying assets. They were the first to start putting rates up. I think that’s to their credit. I think that they are aware of this problem more than other central banks. And you’ve got to acknowledge that, which is why we’re first in the hiking cycle, in the developed world, we’re first in the hiking cycle. 

So from my point of view, they have got this challenge about putting rates up. 

Step back from it all and think about what we talked about to start the conversation: low rates stimulate growth, because you consume, high rates stop growth because you save. Okay. So there’s a great desire to find a neutral rate, a rate that doesn’t encourage you to consume, a rate that doesn’t encourage you to save. So, let’s call that a neutral rate. If we step back and think historically bond investors and economists have thought the neutral rate is the interest rate, less the inflation rate. So let’s say the inflation is always 2% and interest rates are 2%, at the end of the year, that’s neutral. So nothing’s happening, you know, that’s a neutral interest rate that you have. 

At the moment, obviously inflation’s way above 2%. So, we’ve got a very, very stimulative real rate. But if inflation is 2%, then bond yields should be 2%, to be neutral. So that’d be the first stopping point in where 10-year bond yields can go to, or 30-year bond yields, or one-year yields or base rates or whatever they call it these days. You know, that’s where they can go to.

A further school pre the crisis, the school would be different. The school would argue the neutral rate isn’t where inflation is, it’s where real GDP growth is. Because it’s inflation plus growth. The growth averages 2%. So the argument going in before the financial crisis, a natural rate was 4%.

DM: 2% of GDP and 2% of interest rates.

RW: Is real growth. So if [inaudible] gains grow by 2%. Therefore the economy is growing that rate. If you can, if you can grow at 2% and you can borrow at 0%, you borrow and grow. So there’s got to be some sort of equilibrium somewhere. So the concept is that the neutral rate is either 2%, assuming 2% inflation, or 4% assuming 2% inflation and 2% growth. 

Now at times, interest rates need to be above neutral because you need to slow the economy down by getting people stopping consuming and start saving. And at times it needs to be below neutral in order to get people to consume and stop people saving. So that gives you a guideline. So it depends if you take the post financial crisis argument, you’d say neutral is 2%, pre-final crisis you would argue that neutral is 4% and then rates can go above or below those. We can sit and talk about whether it should be 2% or should be 4%, but basically they’re below 2% so we don’t really need to have that discussion until we get there. 

DM: Cause we’re not there. 

RW: Exactly, then we know which side the equation we’re on. And one other thing that’s very, very different this time round. And this is the, and you, again, it’s useful to look back, the inflation we have now, wasn’t caused by interest rate moves, the central bank moved interest rates from a half to zero, that didn’t cause 7% or 8% inflation. 

What caused the inflation is obviously you know, hopefully some temporary effects from what’s been happening in COVID. It was… a big budget deficit obviously creates the inflation and that was facilitated by the printing of money. So this time round, when the central bank is already acknowledged, when it gets to a certain rate, it is going to stop putting short term rates up and it’s going to unwind the unconventional policy it’s had. So the big question for us is what happens when, as opposed to printing money, they decide…

DM: They start taking it away

RW: Destroying it, burning it, removing it. I’m not quite sure what word they’re going to use, but ‘deprinting’. I mean, canceling is probably the appropriate word to use. So they cancel the money they printed. I think that’s going to be very, very interesting for the markets and how that works.

[15:11]

DM: So look, let’s talk about your most flexible fund, Optimal Income. In Optimal Income you’ve got lots of choice from sort of government bonds, investment grade, high yield, and you can even buy a few equities should you choose to do so. Where are you finding opportunity today?  

RW: The purpose of this fund is to find the optimal income stream. So, we think the income stream is a function of two things. Are they going to pay you? That’s the credit risk, which is less so generally in governments and more so as you go towards investment grade and high yield. And secondly, how do you value that? Well, that’s the function of the debate we’ve had already, inflation. If inflation is really high, then that income stream is worthless in a number of years’ time. If inflation is very low, that income stream is worth a great deal. So, it’s a mixture of the credit quality and the value of that income stream. So the terms of that would be the probability of default risk in bond world language, defaulting [and duration].

DM: Defaulting is a company going bust and not being able to pay you for lending them money. 

RW: Yeah, yeah, exactly. So you’d expect to get paid more, if people have got friends, they’re trustworthy, they might lend money to, other ones they might not sign up to lend money to, you know that’s the kind of you exercise that we work through on a more, you know a wider basis looking globally. So they’re the two things we’re trying to find this optimal income stream. And that applies to all assets. It applies to bonds, it applies to equity, it applies to property. They all produce an income stream and you work out, you know, what the present value of that building, what the present value of that equity is, or that bond. It’s a bit easier maths-wise to do it in bonds than it’s in the others because the nature of bond investing. So that’s the starting point we have. 

And we look at these asset classes that behave very differently. You know, government bond funds you have very little credit risk, investment grade has more credit risk, and high yield has lots of credit risk because obviously they’re weaker counterparts in terms of [they] have more borrowing, maybe less predictable earnings and maybe more borrowing and less predictable learnings. And so we work through that and that’s the area we go through. Where we differ on this fund from traditional bond funds is we look globally. We’re not just focused on the UK. We hedge all the returns in our sterling class back into Sterling, so we’re not an FX type fund…

DM: So you’re not taking currency risk. You’re just, you’re using global bonds, but without that currency risk.

RW: Yeah and that just gives us a big pool to invest in. It’s a bit like I mean, one of the challenges that face that all investors is, if you decide: I want to buy an equity and you just look to the FTSE 100, you’d have a very different outcome than if you look globally to where things would be.

DM: Of course. 

RW: 25, 30 years ago, the FTSE 100 would’ve been a good proxy for where you can invest in the world, because we would’ve had lots of tech. Would’ve had lots of different businesses. But now the sector, the industry’s become very sort of sector based. I’m sure it’s a challenge that you and other fund managers and people listening to this have found over time. You have to look globally to invest. And we do a similar thing on bonds, you know, to have a, a wider pallet of issues to buy from. 

So with that flexibility again, if we really like credit risk, we can own lots of high yield. If we are really defensive, we can own lots of safer government bonds. If we think growth’s going to be very high and inflation’s going to be very high, we won’t want to own long-dated bonds whose value will fall. And if we think that interest rate rates are coming down and inflation’s coming down, we will want to lock into that opportunity by buying these longer term income streams. So it’s an exceptionally flexible fund, which means it behaves very, very differently from many other funds, which are far more index aware, or following, you know, an index. This very much investment-led. 

We have other funds that, you know, are more conservative, are more tailored to look at an index, but this particular fund is the widest pallet for me to invest in. And to that extent, sometimes we find the income stream available from equities attractive versus the income stream available for debt.

[19:17]

DM: Do you have any equities in the fund today with that sort of maybe wanting to get away from longer duration bonds ie bonds with longer income streams, are equities then attractive in this inflationary environment?

RW: We have around about 5% of the NAV in equities, which is, the fund’s been going for 15 years now. It’s hard to imagine…

DM: Is that the highest you can go to, is about 5% isn’t it? 

RW: No average has been 5% over the life of the portfolio. The highest we’ve been to was probably in 2013, 2014 when equities were exceptionally good value when we got to over 10% of NAV, and there was some very attractive income streams there. So really we look on a case by case basis. 

If the equity part of the capital structure is really, really good value versus where the bond part of the capital structure is, then we will reduce our exposure to the bond part and increase our exposure to the equity part. At the moment, that’s very biased towards value stocks. So it’s very biased towards oil and gas, tobacco, telcos, autos. So it’s very much in that value basic place where we find value. That’s not always been the case. Back in 2012 and 2013 – it’s hard to imagine, but back in 2012 and 2013, we bought things like Microsoft, Google, and Apple, and you think, well, why are you buying those you’re a bond fund? Because strangely in 2012, 2013, Microsoft, Google and Apple were value stocks.

DM: Yes, they had a decent yield.

RW: They were trading on low PE, the market told me these things are never going to grow again. I don’t care if they grow or not, as a long as they pay me the income and don’t decline, I’m okay.

DM: Yep. 

RW: So it’s quite interesting this whole concept about what a value stock is, what a growth stock is. A lot of it is based on what’s observed, not what actually the company’s doing, and it’s my job to think what the company’s actually doing. Not just take, you know, some indicies or some article saying this is a great growth company. You know, we try to look beyond that and see what’s actually happening under the ,under the bonnet of the company, it’s something that M&G do across all sorts of all sorts of areas.

DM: Richard, thank you so much for taking the time and explaining to our audience how you look at that short and long term interest rates, how they actually lag and effect the economy and how those effect bonds and you about the opportunities that you have within your own fund. So thank you very much for your time.

SW: M&G Optimal Income is M&G’s flagship offering. As we’ve discussed, this ‘go-anywhere’ fund has a flexible mandate, which enables the manager to shift the interest rate exposure and to invest across the fixed income spectrum. The fund can, and often does, invest in some equities. To learn more about the M&G Optimal Income fund or other Elite Rated funds run by Richard Woolnough, please visit fundcalibre.com and don’t forget to like and subscribe to the Investing on the go podcast for more episodes each week.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.