The Bank of England (BoE) rarely springs a surprise. In fact, part of its remit is to provide clear clues to the market to help smooth out foreseeable economic bumps. Nevertheless, an unprecedented news flow and the gathering prospect of inflation has prompted one of the most eventful calendar quarters in recent UK monetary policy history.
Within this unpredictable environment, we have had to ensure performance continuity. CCLA’s approach to managing the Public Sector Deposit Fund (PSDF) is to keep significant short-dated exposure to be able to readjust at speed, while at the same time making relatively small but frequent long-term investments to benefit from higher rates.
But what is driving this situation? To flesh out recent BoE actions, on 17 October Governor Andrew Bailey warned the G30 group of central bankers that the Bank would ‘have to act’ to address a growing inflation risk that appeared to be becoming increasingly embedded in the UK economy.
His comments on 4 November appeared to indicate a 0.15% hike in the Official Bank Rate, or so the market surmised, with the chance of more tightening before year-end.
The BoE then confounded expectations by holding the Official Bank Rate at 0.10% by a majority of 7–2. In its quarterly report, the Monetary Policy Committee (MPC) sent a firm signal that if upcoming labour market data remained strong in the coming weeks, it would probably raise rates.
The BoE then confounded expectations by holding the Official Bank Rate at 0.10% by a majority of 7–2. In its quarterly report, the Monetary Policy Committee (MPC) sent a firm signal that if upcoming labour market data remained strong in the coming weeks, it would probably raise rates.
But then came the Omicron variant. The market understood that the emergence of a highly contagious new Covid-19 variant – and the potential downward pressure on the economy and employment – would all but rule out acting in December.
This view became more entrenched when hawkish MPC member Michael Saunders said the Omicron coronavirus variant added uncertainty to the economic outlook; there were ‘advantages’ in awaiting more information before tightening monetary policy.
Given this preface, the decision to increase the Official Bank Rate by 0.15% on 16 December surprised many. While the MPC described the decision as a close call, the 5.1% November inflation reading was too high to ignore.
‘We’ve seen evidence of a very tight labour market and we’re seeing more persistent inflation pressures,’ Andrew Bailey said after the decision. ‘We’re concerned about inflation in the medium term and we’re seeing things now that can threaten that. So that’s why we have to act,’ he added, acknowledging that inflation was likely to breach 6% in early 2022.
The BoE indicated that further ‘modest’ rises in interest rates could be required to bring inflation down to its 2% target in the coming months.
The outlook for 2022
As we enter 2022, the path for interest rates appears to be upwards but the exact timing and amount of likely policy tightening is unclear.
What is certain is that Omicron will cause significant short-term damage to the economic recovery, cutting growth in the final quarter of 2021 and into 2022.
The BoE will need to assess the severity of the variant and any further restrictions before deciding whether to increase its Official Bank at its February meeting. Should some form of lockdown be needed, then we expect rates to be on hold to support the economy perhaps until May.
The risk remains, however, that inflation continues to exceed expectations. If this is the case the Bank may need to act quickly.
While the rate of price change should fall back as we move into the second half of 2022, the worry remains that companies respond to the past year of significant inflation by raising prices while workers increase wage demands. That will keep inflation well above target and increase the need for, and likelihood of, further increases in Official Bank Rate.
Discussions between the BoE and businesses suggest that inflation is likely to be persistent with companies planning price rises of 4.2% on average over the next twelve months. As a result, further increases in the Official Bank Rate are likely as we go through the year. We see the rate back at its pre-pandemic level of 0.75% in August, with a further increase to 1.00% possible in November.
One additional dynamic is that UK households may be starting to spend some of the £170 billion of excess cash built up during the pandemic; the latest savings figures show deposits accrued in the third quarter back below their pre-pandemic average.
This is likely to alleviate some of the downward pressure on the yields banks are willing to offer and may add further momentum to money market rates as we move through 2022.
Managing this nuanced environment for a net yield of 0.1450% 1
The Public Sector Deposit Fund (PSDF) is specifically targeted at public sector bodies. At 5 January 2022, the fund had £1.7 billion of assets under management from 650 clients from across the public sector, with 72 of them using the ICD platform.
The fund has an approved list of over 50 financial institutions with whom it can make investments. This list is under constant review by CCLA, and fund investments are typically spread across 25 to 35 institutions at any point in time.
Investors can take further comfort from the fact that the PSDF has been awarded the highest AAAmmf rating from Fitch Ratings. This reflects its adherence to strict regulatory rules ensuring diversity and liquidity. It is this goal which comes first in our management of the PSDF, and it is why authorities can be sure that their investments benefit from CCLA’s low-risk approach.
In a world of uncertainty and increasing social, governance and environmental demands, councils and other authorities can also be assured that our active stewardship programme seeks to push for improvement in the companies we invest.
This rapidly evolving interest rate environment presents continual challenges when operating a money market fund. Taking the funds’ average duration too long might mean it was unable to take advantage of the upticks in rates that look likely to occur over 2022. Keeping the average duration too short could result in PSDF shareholders failing to benefit from higher rates on longer-dated investments.
Our approach is to structure the fund so that significant short-dated exposures are maintained, providing both enhanced liquidity and the possibility of quick readjustments to a new rate environment.
However, we have consistently looked to make relatively small but frequent long-term investments, allowing the PSDF to benefit from the yield premia on offer for longer dated investments.
In this rapidly evolving and nuanced rate environment, we believe this is the right approach to ensure performance for PSDF shareholders.
[1] As at 5 January 2022