Why higher interest rates aren’t the answer to higher inflation

Chris Salih 01/11/2021 in X Strategy

As 2021 has progressed, risks have risen almost in line with stock markets, according to David Coombs, manager of Rathbone Strategic Growth Portfolio.

In this investment update, David gives his outlook for markets and tells us how he has positioned his multi-asset fund to take advantage of opportunities and protect assets from inflationary pressures.

The inflation conundrum

“As economies get back into their rhythm, markets for everything from labour and energy to bread and computer chips have been upended,” commented David. “This sent inflation higher in most of the world as businesses struggle to attract staff and buy the essentials. 

“The headline rate of UK inflation was 3.2% in August, but September and October have been chock-full of shortages: fuel, gas, staff, groceries and other imported goods. These are global issues, but they have hit the UK harder because of poor energy storage and bad labour market policies. 

“All this puts the Bank of England in a difficult position. British inflation is almost definitely going higher in coming months. However, ‘cost-push’, driven by higher supply costs cannot be solved by higher interest rates. Raising rates can only reduce households’ and businesses’ demand for goods and services by increasing the cost of borrowing and boosting the incentive to save. Raising rates cannot get the fuel to the pumps quicker, make it rain for the soybean crops in Brazil, grease the export of raw materials from Australia or open ports in China. If the BoE acts too quickly, it could make things worse. It may even spark stagflation – putting the economy into reverse while persistent inflation eats away at people’s spending power.”


“China has battled a dangerously inflated property boom for many years,” continued David. “Developers borrowed heavily from investors all around the world, using the cheap debt to finance countless apartment blocks. Demand for these was huge. However, many companies overstretched themselves, repaying maturing debt with ever more debt as they chased sales growth. This has finally come to a head with Evergrande, China’s largest real estate developer defaulting on debt and becoming the world’s largest zombie company after China tightened up leverage rules. 

“The government is trying to stop runaway price inflation in homes and encourage developers to become more financially responsible. It seems to have had the desired effect on property prices, but it may also destroy developers rather than bring them to heel. 

“Investors are worried that China may allow Evergrande to fail in the messiest possible fashion as a warning to the others. If so, this could set off a wildfire of fear, fire sales and plummeting prosperity that would dramatically slow Chinese GDP growth. That would have a knock-on effect for the whole world. We expect the government to wind down Evergrande over the coming years, parceling parts off to state-owned banks, perhaps creating a bad bank for the most toxic assets and letting bondholders take a bath.”

Insurance policies for wobbly markets

“Low bond yields make stocks, bonds and property all expensive,” said David. “This means it is harder to reduce the correlation of portfolio returns, which is a key measure of our risk. To boost our diversification over the past year or so, we bought several different structured products, which are contract-based investments with banks. That means that if certain events happen or market measures hit certain targets, we are paid a certain return, while if the opposite happens, we lose the return and sometimes some of our capital. 

“The most recent is the Société Générale VRR Index Structured Product, which makes money if the volatility of US Treasury yields increases. Any increase in the size or frequency of moves in US treasury yields is good for this investment. However, if yields just amble along with little movement, we lose money. We view this product as an insurance policy for wobbly markets.

“As a defence against a sustained uptick in inflation, we added a lot of US Treasury Inflation-Protected Securities 0.25% 2025 bonds (TIPS), whose coupons and principal are linked to US CPI (consumer price index). The average rate of inflation required over the life of the bonds to make these bonds more profitable than conventional US Treasuries – which is known as the “breakeven rate” – has fallen back slightly in recent months. 

Getting currency exposure

“We added to the iShares China CNY Bond ETF, which invests in investment-grade bonds issued by the Chinese government and state-run development banks to further diversify our currency exposure. These bonds should also hedge us against a global economic slowdown as that would send their yields lower, while giving us better interest rates than we could get in the West. 

We also added to the JPMorgan Emerging Markets FX Momentum Structured Product. This contract gives us exposure to a ‘momentum’ index of emerging market currencies. It uses price trend data to try to anticipate whether the basket of currencies will rise or fall against the dollar. This should enable us to generate positive returns in benign markets, and historically it has provided some protection in times of crisis as emerging market currencies typically sell off against the dollar, and the index model has picked up on this trend and moved to a long dollar position.

“While we expect the pandemic-driven supply-demand imbalances will be sorted out by the market, there is the risk of commodity prices continuing to rise and staying high for some time. To protect ourselves against this, we added to our holdings of Canada Government 0.5% 2030. We should also benefit from currency appreciation if higher commodity prices heighten UK inflation and send the pound lower.

“Meanwhile,” concluded David, “we sold the MSCI Far East Ex-Japan ETF to reduce our Asian exposure. We took profits from some of our more high-flying stocks, including laboratory network Eurofins Scientific, diabetes monitoring business Dexcom and creative software developer Adobe.”


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