Holding our Interest

By Alexander Davies | 13 Aug, 2008 

Last Thursday the Bank of England voted to keep the interest rate at 5% for the fourth consecutive month; despite pleas from many to control inflation by raising rates. Many people believe the next move in interest rates should be upwards but in our opinion rates should be reduced.

Inflation is the highest it has been for some time, but we think it is important to consider the causes; namely high oil and food prices. High food and oil prices are global issues that cannot be controlled by the Bank of England. Core inflation, a measure that does not include oil and food, is much lower at only about 1.5%. Providing there are no widespread wage increases we believe core inflation should remain low, but higher salaries are likely to encourage further inflation.

An additional issue to consider is that recent figures released show the UK economy is slowing. A rise in interest rates will slow production further; another incentive to cut rates.

A drop in rates can relieve pressure on the economy and businesses. There will be beneficiaries, for example corporate bonds. Bond prices tend to move in the opposite direction to interest rates, so if rates fall bond prices are likely to rise.

The stock market could also benefit. Historically falling interest rates have provided a boost to equity markets. In particular equity income funds can prosper. The managers look to invest in stocks with a high yield; where prices have been pushed lower but prospective dividends are high. In a low interest rate environment the yields on equity income funds, together with the prospect of capital growth, make the funds look doubly attractive.

Generally yields on both equity and bond funds are the highest they have been for years. It is not uncommon to see both equity income and high grade corporate bond funds now yielding 5.5% or 6%. Investors will potentially enjoy high yields and, if prices rise, also benefit from capital growth.

Of course there are no guarantees; interest rates could rise and equity and bond prices fall. Also the oil price has retreated recently; as I write oil is trading at $118 per barrel, down from its recent peak of $145. This is already helping to ease inflationary pressures, but the price is still almost double what it was a year ago so will have to fall a lot further before the pressure is really lifted.

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