Tips For Dealing With Rising UK Interest Rates

On Thursday, 2 November 2017, the Bank of England’s Monetary Policy Committee (MPC) voted to hike interest rates by 25-basis points. This was the first rate hike by the BOE since 2007, and it marks a dramatic reversal in policy by one of the world’s major central banks. Several important factors precipitated the rate hike in the United Kingdom, notably runaway inflation (hovering around 3%), and declining real wage growth (2.1% – 2.2%). The UK has been beset by a series of economic hardships following the June 23, 2016 Brexit referendum. Increased uncertainty in the workplace and decreased foreign direct investment (FDI) have fueled lackluster economic growth in the UK.

Bank of England governor Mark Carney wasted no time in the recent decision to raise interest rates in the UK. The MPC agreed upon a 25-basis point hike to bring the UK bank rate to 0.50%. While this move is insignificant in the broader scheme of things, it represents a reversal in policy that heralds a new policy of gradually increasing interest rates. For the BOE, this about-turn is in line with monetary policy movements in the US. The global economy is on the mend, and as is so often the case during economic recoveries, interest rates gradually begin rising. Wilkins Finance strategist Montgomery Perkins believes a rate hike was the right decision: ‘This will give the BOE, the Fed, and the ECB greater leverage to act if economic conditions worsen. Higher interest rates invariably mean that there is more ammunition available to kickstart economic activity if a downturn occurs.’

What effect does an interest rate hike have on the GBP?

The initial reaction of the GBP against the EUR and USD was negative. After the announcement was made on Thursday, 2 November 2017, GBP plunged 1.7% to the EUR (1.1204) and it dropped to 1.3063 against the USD (down 1.36%). Typically, this is not the reaction one would expect from a rate hike. Increases to the bank rate make a country’s currency more attractive to traders. The effect of a rate hike in the UK is positive for savers over the long-term, but negative for those with high levels of variable debt such as credit card debt and variable-rate mortgages.

Perhaps the reason for the decline in the exchange rates vis-à-vis the GBP were the minutes of the MPC decision. In its analysis of the UK economy, the Bank of England governor and MPC officials cited inherent weakness in productivity growth in the UK, including high inflationary pressures. These types of statements are counterproductive to buoyancy of the GBP, and overall UK economic growth prospects. While a rate hike typically bolsters the performance of the economy, sentiment expressed by committee members could have the opposite effect. The most pressing concern for the UK economy is not a 25-basis point rate hike – it is the status of ongoing Brexit negotiations. The performance of the UK economy remains in doubt given that there is no blueprint for Britain’s extrication from the European Union.

What financial assets benefit from rate hikes?

When central banks increase interest rates, the general perception is that the economy is on the mend. This bodes well for indices like the FTSE 100 index, the Dow Jones Industrial Average, the NASDAQ, and the S&P 500 index. Rate hikes should technically have a negative effect on indices since it means that listed companies will be paying more for their loans (borrowed funds). However, the implication of a rate hike is that the economy is improving. This bodes well for the export potential of listed companies.

In any event, most of the increases will be passed on to customers in the form of higher prices. Dollar-denominated commodities like gold, typically react negatively to higher interest rates. Since gold is a non-interest-bearing asset, it does not appreciate when rates rise. Gold tends to prosper with low interest rates since the opportunity cost of holding gold is lower. Most of the time, there is a non-linear correlation between interest rate hikes and the variety of efficacious investment ideas. Multiple factors come into play, and markets often react contrary to economic theory.