Why UK interest rates will rise

Bankruptcy levels are at record highs and low income families are having difficulty making ends meet. And yet the Bank of England's next move is likely to be a hike in interest rates, rather than a cut, says Brian Durrant of the Fleet Street Letter. Why?

Five months into 2006, and three compelling investment trends stand out. These trends are accelerating at a rate we never imagined.

On the one hand, we see the spectacular emergence of an ber-rich class in London and the South East. Compare that with the soaring number of people declaring themselves bankrupt and the rise in company liquidations outside the financial sector. Then set them both against the backdrop of runaway commodity prices.

All three trends are related, of course. Indeed, they share a common root cheap credit, itself born of the lax monetary policies that have marked the early 21st century. So far, its impact appears diffuse, but today, we will examine how these trends interrelate.

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For Britain's super-rich, things have never been so good. Booming stock markets, escalating property prices, a takeover mania, the sudden growth of hedge funds in London, investment bankers dripping with City bonuses... they have all contributed to this explosion of wealth.

The combined assets of the top 1,000 listed in The Sunday Times Rich List has climbed by more than 21% in a single year to £301bn. Indeed, this figure has trebled since Tony Blair became Prime Minister in 1997.

But this is a global phenomenon. The richest 50 in Europe have increased their wealth this year by an even greater 33%. And overseas billionaires from India, Russia and Scandinavia now make a beeline for London and the South East of England. Some 52% of The Sunday Times Rich List live in this region of the UK, contributing to the renewed property boom sweeping the most exclusive parts of the capital.

House prices in central London have risen by 14.7% in a year. In the last four months alone, property prices in Chelsea are up a staggering 11.8%. A typical two-bedroom flat in the area would now be worth £500,000. Agents Knight Frank have noted a huge supply/demand imbalance in the market for top-end homes. It's the most lopsided for a decade with supply falling by 21% in the last year and demand soaring by 43%.

This is a localised boom, however. Outside the boomtowns of Central London and its stockbroker belt, the housing market has been much weaker. Prices in Scotland are up just 1% since the New Year. Yorkshire, the North West and South West are up 2% over the same period.

For more humble households, there are serious strains on their domestic finances. In the first quarter of this year an all-time high of 23,351 people sought individual insolvency through the courts, a 73.4% increase on the corresponding period last year and 12.9% higher than the previous three months. Individual Voluntary Arrangements (IVAs) accounted for two-thirds of insolvencies, the rest were bankruptcies.

The ease of obtaining credit, plus legal changes making it simpler to go into bankruptcy and a more relaxed attitude to debt in Britain generally are the main factors behind these soaring insolvencies. Although recently we have seen a moderating of net unsecured lending to individuals, we would need a prolonged period of reduced credit to bring the UK's private finances back into balance.

It's not just individual consumers that are drowning in a sea of debt. Business insolvencies also rose in the first three months of this year. Company liquidations increased by 17% on the first quarter of last year to stand at 3,439. Within this total, compulsory liquidations saw a 30% rise, which outstripped voluntary liquidations up just 10%.

Retailing and manufacturing were the sectors hardest hit. The small corner shop or the independent filling station is struggling to compete on price and location. Liquidations in the chemicals industry were up a massive 62% which brings us to the commodity-price boom.

Copper has risen more than 70% so far this year, recording fresh all-time highs of $7,780 a tonne, even after China hiked its rates late last month. It seems that supply concerns in mines in Chile and Mexico are fuelling price gains in this phase of the bull run.

Other industrial metals are following suit with aluminium breaking through the $3,000 barrier for the first time in 18 years. Zinc touched a peak of $3,492 per tonne last week.

It was only in the middle of last month that the price of gold conclusively breached the $600 per oz mark.

Three weeks later, amazingly, the $700 level has been breached. According to Bank of England data, the yellow metal has reached a new all-time high for British investors above £376 per oz. This signals much higher inflation ahead. But why the sudden leap?

At the end of last month a G7 communique called for greater currency flexibility to reduce global trade imbalances. This has pulled a rug from under the US dollar and in turn has helped underpin higher gold prices in all currencies this month. But there is a new story, too.

Chinese economists have suggested that the country should quadruple its bullion reserves to protect against a falling dollar. If the Bank of China starts to switch a portion of its $875bn foreign exchange reserves into gold, it would electrify the market.

Oil prices also remain firm, another sign that commodity-led inflation cannot be deferred much longer.

Brent crude was just shy of $75 a barrel last week after Bolivia's decision to seize control of foreign-owned gas fields added short-term fears of disruption to longer-term concerns about global supplies. At the same time the Saudi oil minister has said that he expected more assaults on the Kingdom's oil infrastructure following the foiled attack on the Abqaiq refinery, which processes two-thirds of Saudi output, in February.

So low rates have encouraged private individuals to take on more debt than they can manage. At the same time cheap financing costs have fuelled the boom in mergers and takeover activity. Excess liquidity has also boosted the prices of most asset classes, including commodities, with operators in the financial sector being key beneficiaries.

But these three developments don't simply share a common root. The strong increase in energy prices is responsible for that high number of bankruptcies in the chemical industry. At the same time, booming London house prices and soaring commodity prices put pressure on lower-income households. They also make it difficult for the Bank of England to cut rates to alleviate distressed borrowers and struggling retailers elsewhere.

The markets now expect the next move in UK rates to be up. In short, as the boom in asset and commodity prices continues, it is difficult to see the tide of personal insolvencies and corporate liquidations ebbing.

By Brian Durrant for The Fleet Street Letter

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.