With interest rates set to remain higher for longer and inflation gradually falling, money market funds can offer investors a way to access positive real yields on cash, says Alastair Sewell.
Read this article to understand:
- The effect of rising rates and inflation on money market fund returns
- Why real cash yields look set to turn positive
- The longer-term outlook for UK rates
ALTO, or air launch to orbit, is the process of launching a spacecraft from another aircraft. As the launch vehicle approaches the zenith of its parabola, the spacecraft takes flight.
The analogy is meaningful for cash investors. Interest rates are now at or near their peak. The Bank of England (BoE) increased the base rate to 5.25 per cent on August 3, 2023.1 Our most recent House View anticipates the UK base rate peaking at 5.75 per cent.2
While other indicators and market observers may position the peak higher or lower, there is strong consensus that we are nearing peak rates, if we are not already there. We expect central banks to remain in restrictive territory for some time – in other words, we don’t think rates will fall anytime soon. This means cash investors can expect yields on money market funds (MMFs) to remain high for the foreseeable future.
However, with inflation so persistently high, the real yield investors receive has remained stubbornly negative. The real yield is the nominal yield minus inflation. When the real yield on cash is negative, inflation erodes the value of cash; conversely, when it is positive, the value of cash increases.
Real yields look set to turn positive soon. Nominal central bank rates are set to increase, or at least remain high, while inflation is beginning to fall. Or, to return to our spacecraft analogy, cash returns are about to be launched into the stratosphere, as the negative drag from inflation falls away.
Figure 1: UK real yield (per cent)
Source: Aviva Investors, Bloomberg Economist Forecast Panel, June 30, 2023.
Headline inflation set to fall
Current economist forecasts suggest real yields on cash will turn positive in the fourth quarter. For this to happen, inflation needs to fall, while central bank rates needs to remain unchanged.
We expect headline inflation to continue to decrease, as the contribution from energy turns negative. The fall in energy prices (oil prices are down around 25 per cent and European gas prices 75 per cent from their 2022 average) has resulted in headline consumer price index (CPI) inflation starting to come down sharply.
Figure 2: UK inflation forecasts (per cent)
Source: Aviva Investors, Bank of England, Bloomberg economist panel. Data as of July 2023.3,4
The pass-through of lower energy prices into fresh food and manufactured goods prices should also help to bring headline inflation down. Due to these factors, the BoE forecasts inflation should return to its two per cent target by early 2025.5
The path to two per cent
While the energy effects dominate headline inflation rates, core inflation measures remain uncomfortably high. The BoE is likely to face further challenges in keeping inflation at target.
Inflation in the UK has eased, but the path to the two per cent target is not clear. Additional pressures are building, such as the termination of the grain supply deal between Russia and Ukraine, banning of rice exports by India and decimation of the olive oil crop in Spain. This could see food, and therefore headline inflation, go higher again. With core inflation still high, this isn’t supportive of inflation moving to target in the near future
Prices are still rising
The latest UK inflation print had CPI at 6.4 per cent at the end of July, down from 7.3 per cent at the end of June.6 This is a positive development, but prices are still increasing at a rapid pace and well above target.
Figure 3: Components of UK CPI (per cent)
Source: Aviva Investors, Office for National Statistics. Data of as August 16, 2023.7
We expect moderating service inflation, as well as a softening in food inflation, to lead to lower UK headline numbers over the next few quarters. Goods inflation has declined largely because of falling energy prices, despite surprisingly high food inflation.
As of the last inflation print, services inflation was still at all-time highs at 7.4 per cent year-on-year, in line with the trend in earnings. This points to the importance of underlying labour-market dynamics in shaping the outlook for UK inflation.
The BoE projected private sector regular pay would slow to six per cent at the end of 2023 from the current level of 7.8 per cent (the highest since records began), along with a softening in vacancies and gradual rise in unemployment. Unemployment at the end of June was 4.2 per cent, 0.3 percentage points higher than at the end of the prior quarter.8,9
This suggests services inflation has peaked, but is likely to fall at only a gradual pace. The most recent Purchasing Managers Index (PMI) numbers in the UK suggest we may be finally seeing softness on the demand side, which should contribute to a further easing in inflation pressures.
Rates to remain higher for longer
Persistently high inflation means rates will have to remain high for a sustained period, in our view. The BoE states: “The MPC [Monetary Policy Committee] will ensure [the] Bank Rate is sufficiently restrictive for sufficiently long to return inflation to the two per cent target sustainably in the medium term, in line with its remit.”10
We think the latest inflation print, in combination with a more mixed wages report, suggests there will be further rate rises.
Figure 4: Aviva Investors House View UK forecast
Source: Aviva Investors, Bloomberg, July 2023.11
This has important implications for real yields. Mathematically, if the current central bank rate remains unchanged and inflation falls as forecast, real yields will turn positive.
Figure 5: Bloomberg World Interest Rate Probability
Source: Aviva Investors, Bloomberg WIRP. Data as of August 24, 2023.
Most market participants also expect further rate rises. Since we published our House View in July 2023, market expectations for peak UK interest rates have fallen to around 5.75 per cent from a prior high of six per cent. Despite this, market pricing still implies around 50 basis points (bps) of further rate hikes.
We don’t expect the decreases in inflation will be sufficient for the BoE to credibly start cutting in the short term. The BoE has little room to manoeuvre from holding rates higher for longer to combat inflation. We believe current market pricing of the first cut by July 2024, followed by roughly 125bps of cuts in the ensuing two years, is not unreasonable
MMFs as a tool to access real rates
To gain access to positive real yields, investors need to be able to access market rates. MMFs provide such access. Sterling MMFs had an average gross yield of 5.18 per cent as of August 9, 2023, rapidly approaching the recently increased central bank rate.12
Bank deposits typically pay a rate of interest below current market rates. According to the Office for National Statistics, the average interest rate on UK household deposits was 2.18 per cent at the end of July. This average will include a variety of sight and term deposits.
Large institutional investors will almost certainly be able to access higher rates from banks. However, these are still likely to lag market rates and may feature additional conditions such as a specified term (e.g., a six-month deposit), whereas MMFs typically provide daily redemptions and subscriptions.
Arguably, the need to access market rates using tools like MMFs is more acute than ever. The ratio between the average rate paid on bank deposits and current market rates (the SONIA overnight index) has plummeted to the lowest level on record. So, while cash rates have improved, they have not improved to a level at which savers are getting anywhere near close to market levels, which are needed to beat inflation.
Figure 6: Spread between bank deposits and SONIA overnight index (per cent)
Source: Aviva Investors, Bloomberg. Data as of August 25, 2023.
Received wisdom tells us that over the long term, investment in risk assets – be they equities, commodities, property or anything else – is a prerequisite to beating inflation. But data tells a different story. Over the last 70 years, the real interest rate has been positive much of the time (see A look back at history). With positive real interest rates potentially available again soon, investors may be able to beat inflation with cash, but only if they can access market rates.
Escape velocity
The increase in central bank rates since 2022 has been positive for cash investors. So far, however, the benefit has been nominal. We are now entering the next phase: a return to the days of real yields on cash.
To gain access to positive real yields, investors must be smart
To gain access to positive real yields, however, investors must be smart. If a bank deposit is paying less than nominal market rates, it may well not be offering a positive real rate. MMFs can be a good option to access these market rates. With interest rates peaking and inflation falling from its recent highs, MMFs look set to blast into a positive real yield “orbit”.
