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Where do signs point?

In my last article, I started to look at how financial advisers can use information and statistics from the financial pages of the quality press to help in portfolio planning for clients.

This week, I turn my attention to the information on interest rates published in the inside pages of the Financial Times. Financial advisers can use this information to derive an understanding of the likely long-term level of future interest rates and inflation.

First of all, we can confirm the current level of interest rates by looking at the interbank sterling overnight rate. At the time of writing, this rate is between 4 and 5 per cent. Of course, this tells us nothing more than is commonly known by most advisers and, indeed, by most of their clients.

To gain an understanding of the market&#39s expectation of future interest rates, we can stay with the money market section and look at the interbank three-month rate, currently standing at 4 per cent. This indicates the average interest rate the market expects over the coming three months and shows a market expectation of a fall in interest rates of around 0.5 per cent.

This analysis of likely future interest rates can be extended, still within the money market section, as shown in the table (below). Hardly exciting stuff, as these rates indicate that the market expects a 0.5 per cent fall in the very short term, after which rates will settle to 4 per cent for the foreseeable future. Of course, speculation remains rife that we may soon see further cuts in short-term interest rates, designed primarily to stimulate demand and to reduce the cost of borrowing for businesses, but these money market rates indicate that the market doubts this speculation.

For a longer-term indicator of interest rates, we need to turn our attention to the fixed-interest Government bond market, noting that the most appropriate figures for our purposes are the redemption yields on appropriately-dated gilts, as shown in the table (right). This indicates a rather unusual anticipated trend. The market – the big institutional investors, assisted by economic research – expects interest rates to remain largely unaltered at a little over 4.5 per cent in the short, medium and longer term.

Usually, there are significant differences in the redemption yields for different dated gilts, showing a clear expectation of expected future interest rate trends. However, for the last few months, the market has seemed uncertain as to whether interest rates are likely to change materially in future away from their current level.

Perhaps of most interest to financial advisers are the longer-term rates, not least because these influence annuity rates which, of course, impact heavily on pension planning, especially at the vesting date, when it is necessary to decide between the purchase of a conventional annuity and one or more of the more flexible retirement income options such as drawdown.

If interest rates are expected to fall over the next couple of decades, we might also expect annuity rates to fall. Such a fall would have a detrimental effect on the income which can eventually be purchased from the drawdown fund (currently, no later than age 75) and should therefore be noted by the adviser as a significant risk at the outset of giving drawdown advice. This risk is noted in all regulatory guidance notes relating to drawdown but is, I fear, sometimes overlooked by retirement advisers.

At present, as we have noted above, the market is not expecting such a fall but it should be noted that market expectations frequently prove incorrect and the adviser should be careful to bear in mind that this technique simply identifies market expectations – it does not claim to give any indication as to the likelihood of market expectations proving correct.

Long-dated gilt prices have benefited over the last few years, in particular, by huge demand from final-salary pension schemes, not least as they are a highly effective asset class to enable a scheme to comply with the minimum funding rate.

We know that the Government is planning to replace the minimum funding requirement as a funding standard in the next few years and, if the replacement benchmark pays less emphasis on holdings of long-dated gilts, then demand from pension schemes is likely to fall.

Indeed, schemes might well significantly reduce existing holdings of these gilts (although the recent announcement that the Boots pension scheme has completely disinvested from equities in favour of gilts indicates that other factors must be taken into account) and so prices of gilts may well fall, meaning that interest rates at this longer end will rise.

Advisers should also note the comparative redemption yields on equivalent government bonds issued by countries in the eurozone (below).

If the UK were to join the common currency, we would also adopt common interest rates. This would mean that either the eurozone countries would have to allow their longer-term rates to fall into line with UK rates (which, as I have noted above, are arguably artificially low due to excessive demand from pension schemes) or UK rates would have to increase to eurozone levels. The latter outcome seems more likely.

Both these special influences indicate a possible increase in interest rates in future years (and an increase in annuity rates?) but, as with all financial indicators, this does not mean that this will come to pass.

The final indicator from the Government bond section is the market&#39s expectation about future levels of inflation. Here, the comparison of redemption yields shown in the table below is instructive. The implied inflation rate is derived from the assumption that, at any point in time, the redemption yields on fixed-interest gilts and index-linked gilts are in equilibrium. This means that the market expects the two rates to prove equal in value over the stipulated term. If not, then the big institutions would stop buying the overvalued gilts, forcing down the price and thereby forcing up the redemption yield to the point where it appears to then to represent equal value to the other gilts.

This is a simple technique for identifying market expectations of inflation but market expectations frequently do not materialise, so advisers must ensure they do not use these indicators as anything approaching a confident prediction of likely trends.

Just a few simple sections of the financial pages provide many indicators with many important inferences for various aspects of a financial adviser&#39s recommendations, including the possible returns from fixed-interest funds and, perhaps more important, the future trend in annuity rates. In the new year, we return to the equity sections of the financial pages and look at the valuation of equities and equity funds.

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