As we start a new year, many of us are asking a familiar question.
It’s one that is very pertinent to just about all of our assets: What’s happening with interest rates?
For many years now, the contrarian view on rates has been ‘lower for longer’. At the beginning of every year I can remember, mainstream City economists forecast rising rates. Every year, they wait for the bus that never comes.
But this year, maybe, just maybe, contrarian investors like us should take the high road instead.
What shock event could finally make the Bank raise rates, after keeping them low for so long?
Runaway rates come down to one thing
Before I answer that, let’s first consider how rates can suddenly jerk upwards.
Look at Russia. In the closing weeks of 2014, Russia’s key central rate was raised from an already-high 10.5% to a staggering 17%. Just imagine the pinch on small businesses and mortgage holders!
Why? It all came down to the plunging rouble. Oil, politics, you name it, it had investors fleeing from the Russian bear. Prime London property is even said to be taking on fresh impetus as frightened money floods in. It’s a classic case of capital flight.
And what can a central bank do to stem the tide? Short of imposing capital controls, there are few tools at its disposal. The big bazooka is undoubtedly interest rates. Essentially, a central bank can bribe people to keep money within the bank’s currency.
So – if you want to look at what causes a shock interest rate rise, look at the currency. A shock rise, as the UK experienced in the early 1990s, comes as international markets lose faith in the currency.
But under what premise might people lose faith in sterling?
Five possible triggers you might not have considered
For starters, look at the outsized UK banking sector. After all, we Brits are big on banking crises!
Remember during the 2008-09 crash, the pound plunged to near-on parity with the euro. That was a rout that took over 30% of the pound’s value. Put another way – that put a 30% tax on European imports!
How about the possibility of an international banking crisis, stemming from Europe as the Greeks, say, bail out of the EU? With Greek elections coming up on 25 January, that spectre is looming once again.
Or a property bust? After all, the recent banking stress tests were not positive for all our banks.
There’s political risk too. With Ukip on the rise at home, the National Front in France, who knows what could happen? Maybe it could be as something as simple as Labour coming into power that causes markets to suddenly wake up to our debt dynamic.
Of course, it could just be totally unfathomable. Like international speculators picking on the UK.
The thing is, the City of London and its financial services industry work brilliantly for the UK when things are on the up. It’s a virtuous cycle of financial assets and property up, richer citizens, more borrowing and more asset price increases. It works on an international scale, as well as domestically. It’s a leveraged bet, and it’s going well just now.
But it doesn’t exactly take much of an imagination to see some sort of problem upsetting the apple cart.
And once the rot sets in, it’s extremely difficult to stop it. Just ask the Russians.
Call yourself a contrarian? Consider this carefully
I know, I know. It all sounds rather fanciful to imagine that the UK could suffer a similar currency and inflationary fate to Russia.
But it is the job of the contrarian to consider situations that seem implausible at first glance. Let us not forget how implausible a rouble rout looked to its poor citizens a few months ago.
Russia has considerable foreign currency reserves (including gold!) to help keep its rouble in check. But its fat bank balance was to little avail as the international markets smelt blood. All that was left in the arsenal was an interest rate shock.
With a cold deflationary wind coming in from the continent, nobody’s worried about rising interest rates anywhere in Europe.
And to me, that feels like exactly the sort of time one might consider a contrarian bet.
If nothing else, getting in now should offer extremely good odds. Short gilts, short sterling, or even short interest rate futures – that sort of thing.
And if shorting is a bit strong for you, there’s always the long dollar trade. Or perhaps you can chip in for a few ounces of gold. There are plenty of ways to take cover.
Nobody knows exactly when, or exactly why the international speculators attack. All we do know is that the UK is vulnerable.
Could 2015 be the year for a sterling crisis?