For all the wailing and gnashing of teeth over the Bank of England’s 13th straight interest rate hike last week (22 June), the nominal base rate of 5% is still some way below the post-1970 average of 6.4%. Even more tellingly, the real rate of interest – adjusting for inflation – is still minus 3.7% using the consumer price index benchmark for inflation and minus 6.8% using the retail price index.

It might not feel like it for borrowers, but monetary policy is still ultra-loose in the UK, because inflation is not under control. If there is any consolation for those with hefty mortgages, inflation does at least help them in some way as it erodes their debt in real terms.

Where interest rates lie, in nominal and real terms, has just as profound implications for investments and portfolios as it does the wider economy as the accompanying table makes clear. Whereas the post-Great Financial Crisis environment of low inflation and low interest rates meant that investors could argue there was little or no alternative to shares, from a yield or capital gain perspective. Central banks’ dash to jack up interest rates and the effect of their efforts to quell inflation upon bond yields means the picture looks very different now.

The colour of money

The return available on cash, as defined by central banks’ base rates, and by extension the risk-free rate available on government benchmark bonds, sets the reference point by which the attractiveness, or otherwise, of all asset classes will be judged.

The 10-year yield on UK government bonds (gilts) is seen as the risk-free rate and any other investment should return more than that amount to compensate for the additional dangers. The higher the gilt yield goes, the less inclined, or obliged, investors will feel to pay up for alternative asset classes, such as shares (and vice-versa).

Right now, in nominal terms, investors can get a superior yield from 10-year and two-year gilts than they can from equities and for much less capital risk. The picture is the same in the US, even allowing for how share buybacks contribute to total shareholder returns. In the UK, the FTSE 100’s cash return plans add 1.8% to the cash yield on the index, and in the US, the S&P 500’s another 2.5%.

Those buybacks help to keep the total yield balance in favour of equities in the UK in nominal and real terms, while in the US equities still offer more than real interest rates and cash in the bank, once inflation is taken into account.

This may help to explain why stock markets are proving relatively resilient in the UK and continue to barrel higher in the US, even though interest rates are way higher than anyone expected them to be 12 months ago.

Cash and bonds offer competitive yields relative to equities

Real rate of return

No-one knows for sure where inflation and rates will go next – central bankers’ failed ‘transitory’ narrative for inflation in 2021 and panic to catch up with a slew of rate increases in 2022 and 2023 makes that only too clear. Under such circumstances, investors could be forgiven for taking a closer look at their portfolio weightings toward bonds and even cash, relative to equities, especially as any rate cuts during the life of the bonds could mean fixed-income instruments offer potential for capital gain as well as steady coupon payments.

Yet such a decision is not as straightforward as it looks.

Sticky inflation or – worse – a reacceleration in the rate of price increase would do little for the real value of those coupons, even if bonds offer the promise of the return of principal upon maturity. Share prices offer no such safety net and history suggests that a real gallop in inflation, especially relative to prevailing interest rate levels, does them few favours either.

A plunge in real interest rates to deeply negative territory because inflation is soaring does not seem welcome if the experiences of UK and US investors in the 1970s is any guide, or even for that matter portfolios in 2022.

Equally, a sharp surge in real rates to get inflation under control brings different challenges, if the recessions and bear markets of the early 1980s on both sides of the Atlantic are any guide (and we must accept that the past is no guarantee for the future). Spikes into the realms whereby the prevailing Fed Funds rate ultimately exceeded inflation by two to three percentage points also caused trouble for stock markets in 2000 and 2007, but the effects were not felt immediately, and strong bull runs continued for some time in the run up to the final smash.

Precious angle

One asset that loves negative real rates seems to be gold. Surges in inflation, and thus a loss of central bank control as rates lagged, added lustre to the metal in the 1970s and early 2000s, and only fierce efforts to catch up – and hold base rates well above inflation for some time – brought the metal back down to earth.

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