If you think there is no worse predicament for a central bank than a severe loss of credibility, then spare a thought for the Bank of England. With UK inflation, as measured by CPI, running at double its medium-term price stability target of 2.0%, and expected to rise even further to around 5.0% in coming months, UK financial market commentators are having a field day questioning the ability of the rate-setting Monetary Policy Committee.
Regular readers of our ETF commentary may not have been excessively surprised by this high inflation landscape in the UK. Some six months ago, in our article Inflation: Dangers Filtering Through UK Economy, we voiced the case for a healthy dose of inflation protection for UK-centric investment portfolios. The rather punchy inflationary dynamics of late have of course been exacerbated by the rise in commodity prices. But at the heart of the UK inflationary problem has always been the weak sterling policy pursued by the BoE since the onset of the financial crisis.
The whole point of hedging is to do so at a reasonable cost before the event one is hedging against shows its ugly face. We are the first to admit that our warning to seek inflation protection six months ago was something of a last call to passengers to get on the train. And so, this leaves us to ponder whether seeking UK inflation insurance now may not only prove a bit futile, but also a cost-ineffective business.
As often happens with investment decisions, there is no black and white answer to this particular quandary, but to a large extent the answer comes down to whether one has any faith left in the BoE. The bond market started to pass judgement a few months back. Take 10-yr UK government bond yields, which have risen by around 100 basis points from the October/November 2010 lows. While some of the increase has been led by a reverse of investment flows to the benefit of equities, a key driver--particularly since the start of 2011--has been the need to briskly price in inflation risk. Such need has been predicated on expectations that the BoE would continue to favour a low interest rates policy line in order to cement the economic recovery.
Judging by the comments made by the BoE Governor Mervyn King during the presentation of the February Inflation Report, these suspicions may have had a solid base. Interest rates hikes will be eventually agreed upon; but if the majority in the MPC had its way then the pace of delivery would be slow. Market expectations of UK interest rates as measured by the OIS (Overnight Indexed Swap) curve in early February and used as a benchmark by the BoE forecasting machine put end-2011 rates at 1.0%, or 50 basis points up from the current 0.5%, rising further to 2.0% by end-2012 and to 3.0% by end-2013, all at a leisurely pace of 25bps increase per quarter. According to the BoE, this, together with the price dampening effects of the economy’s level of spare capacity, could suffice to bring CPI back down to around 2.0% by the end of the two-year forecast period.
This all brings us back to the original issue under discussion: credibility. Can investors trust an organisation with a fairly long record on underestimating inflation? MPC member Andrew Sentance is telling you not to. This long-standing “policy hawk” has wasted no time in rubbishing the inflation projections included in the February Inflation Report. As far as Mr Sentance is concerned, the continuous underestimation of inflation forces, irrespective of whether these have an imported origin, necessarily increases the risk that the BoE will have to react hastily and by a much bigger measure than would have been desirable.
So, which way to go? Well, difficult to say. In the pure spirit of Economics, there is academic truth to both Mr Sentance’s and Mr King’s theses. But, of course, one of the two will eventually prove wrong. The only near certainty arising from this debate is that, slow or fast, policy tightening seems to be in the offing. And so, whether investors still see the need to stock up on inflation protection or not, the one thing they should consider is that of rebalancing their fixed income portfolios to take account of expected policy changes.
Higher interest rates will have a proportionally more damaging effect on long duration fixed income portfolios. Taking into account all of the above, the case for shortening duration would seem fairly compelling. The number of UK government bond ETFs remains a small portion of the European fixed income ETF market, with only three main providers (iShares, db x-trackers and Lyxor) offering funds. A quick look at the Morningstar ETF database reveals that despite this apparent show of competition, iShares retains an almost monopolistic grip, with assets under management representing close to 97% of the total UK gilt ETF market. This has obvious implications with regards to liquidity and tradability.
The very limited number of ETFs on offer means that slicing and dicing of the maturity spectrum was never going to be as developed as for the EUR-denominated ETF market. But you can shorten duration, albeit at broad strokes. Assuming you are an investor already owning a standard UK government bond ETF, chances are it will be the iShares FTSE UK All Stocks Gilt (IGLT), covering the entire maturity spectrum and with modified duration of around 8 years. Shortening duration can be achieved by switching to the iShares FTSE Gilts UK 0-5 (IGLS), with modified duration of around 2.5 years. Investors wanting to space out the drop in duration will have little option but to tweak allocation to both ETFs, gradually diminishing exposure to the All Gilt in benefit of the 0-5. However, recurrent trading costs would need to be weighed in.
