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Warning: Interest rates can go up

Hot on the heels of my last column suggesting investors might like to look at the M&G UK inflation-linked corporate bond fund, National Savings and Investments has announced the relaunch of index-linked savings certificates after a long period of absence. Although I am a big fan of investment funds for the longer term, investors, particularly higher-rate taxpayers, should consider getting into this new issue before it is withdrawn.

I am pleasantly surprised that the certificates remain linked to RPI rather than CPI but the slight disappointment compared with previous issues of the certificates is the return has been reduced from 1 per cent to 0.5 per cent over RPI. Additionally, there is no option for a three-year certificate and only a five-year one is available but I still expect them to be very popular and they could fill their allocation quickly.

According to Jim Leaviss, manager of the afore-mentioned M&G fund, taking a similar government credit risk with the 2016 index-linked gilt provides you with a yield 1 per cent lower than the certificates. In addition, the NS&I product is tax-free, making it highly attractive as a way to inflation-proof savings on a low-risk basis.

The main risk in buying these certificates is that interest rates move up sharply, meaning rates on cash overtake the headline rate of inflation. On any five-year view, this is a danger but I find it hard to believe that interest rates could be much higher than 2 per cent over the next two years, given the fragility of the economy. The Government and the Bank of England will do all they can to prevent us falling back into a recession. This would be a nightmare scenario that would dent confidence, add to worries about our levels of government debt and cause tax revenues to dry up. I can easily foresee a scenario where inflation remains higher than interest rates for some time and investors should consider partaking in the NS&I issue with part of their “safe” money.

However, contemplating all this did make me think investors might be becoming complacent that interest rates will stay low indefinitely. The trouble is the longer that rates stay at an “emergency” level the more likely they are to rise steeply later on. Consensus thinking seems to be that rates move only gradually by 0.25 per cent at a time but I believe the consensus could be very wrong further down the line. If the inflation genie is let out of the bottle, the Bank of England could have great difficulty getting it back in.

One commentator recently went so far as to say the bottle has already been smashed, and I do have sympathy with the view of Crispin Odey, one of the best macro-economic thinkers I know. He believes the high levels of inflation in emerging markets are starting to make Western production more competitive, which will translate into greater demand and eventually into wage growth

Currently, inflationary problems are being imported from emerging markets and are outside the control of the West but if Crispin Odey is right, interest rates may have to move up sharply in two or three years’ time as central banks are forced to combat wage inflation at home. At this stage, he believes they will find themselves way behind the curve with inflation nearing 10 per cent, meaning rates have to go to at least 7 per cent.

Don’t think rates cannot be raised this rapidly. The US Federal Reserve did so in 1994 when faced with a similar situation. Bond and equity markets fell dramatically. If this does happen, it will, as ever, be a question of timing.

If you want to protect your money in this environment, National Savings index linked certificates, hedge funds and holding straight cash would probably be the order of the day. For now, I think the danger is some way off, but at some stage over the next few years I believe we will look back and wonder how interest rates stayed low for so long.

Mark Dampier is head of research at Hargreaves Lansdown

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