Interest rates and money markets: it’s complicated

You wait over three years to see a rate rise, and then two come along in short order.

The Bank of England’s decision to raise rates to 0.5% last week was interesting, but not really a surprise: inflation is high, growth is recovering to an extent, and as economies re-open, it seems fair that ‘emergency’ low rates are no longer appropriate.

What was more of a surprise, was how fast the market has changed its expectations for the rest of the year. Halfway through last year – even when inflation was clearly on the increase – markets were expecting rates to get to 0.75% somewhere in 2024. They now expect that to happen by this Spring, and for rates to reach 1.75% by the end of the year.

On a basic level, rising interest rates are great for investors’ cash exposure – higher rates mean higher yields mean higher returns. But that isn’t the full story. When allocating cash, many use some sort of laddering approach – keeping daily cash requirements in a very liquid vehicle with very limited risk. This is while pushing cash required into a vehicle that can take limited interest rate and / or credit risk to try to earn more on these assets. So, for instance in our Royal London Enhanced Cash Plus Fund, we typically have a weighted average maturity (WAM) of around 1 year. But when yields rise, any instrument with duration risk will fall in price, leading to negative short-term returns.

How do we as fund managers eliminate this? In truth, we cannot: the only way to avoid short-term losses due to yields moving higher is to have no interest rate risk at all – which means investing in only very short-dated money market instruments, or hedging duration using interest rate futures. However, these will not be attractive options for all clients, who are looking to generate a return greater than that seen as ‘riskless’.

So what can we do? We look to mitigate the impact of rate rises and put in positive elements that will outweigh the negative. In simple terms, when rates are expected to move higher, you buy shorter maturity paper, to help create the maturing proceeds that can be reinvested in instruments with higher yields after these have adjusted. And that’s what we did: we kept at the shorter end of our usual WAM range into the end of 2021. Last week, the entire curve moved higher, pricing in that 1.75% scenario. This is higher than we expect rates to go, as we expect inflation pressures to ease later in the year – if we are correct, then money market yields will start to move lower again.

Given our view, rates in the one year area were particularly attractive and we have been happy to lock these in. This means that we have lifted the overall yield of our RL Cash Plus and RL Enhanced Cash Plus Funds materially. We believe that this will provide a boost to performance over the long term, but also provide a cushion should rates rise even more aggressively than currently assumed. And we maintain our focus on areas such as covered bonds and high quality short-dated credit to enhance the return available on money market instruments.

We will see this strategy play out over the coming months. But after an extended period of low and static money market yields, it looks like assessing the risk profile of cash and ultra-short funds, and how to blend these, will be a key consideration for cash and Treasury investors in 2022.

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.

The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.

The Royal London Enhanced Cash Plus Fund and Royal London Cash Plus Fund are sub-funds of Royal London Bond Funds ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000797. The Company is a UCITS umbrella fund. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.