UK equities
09 Feb 2018 | By Rob James

Rising rates and the banking silver lining

Markets around the world are fretting over the move upwards in interest rates, both at the base rate level (both the UK and US central banks raised rates in the fourth quarter of 2017) and along the yield curve, as measured by government bond yields.

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Rob James, financials analyst and manager of the Old Mutual Financials Contingent Capital Fund, Old Mutual Global Investors

“Markets around the world are fretting over the move upwards in interest rates, both at the base rate level (both the UK and US central banks raised rates in the fourth quarter of 2017) and along the yield curve, as measured by government bond yields. With the Bank of England adopting a more hawkish tone this week, UK investors are increasingly pricing in a move to tighter policy.

“But should we be overly worried? Interest rates have been held down by the authorities for years due to the weakness of the global economy. The reason they are rising now is because the economy is stronger. It’s rather like a patient coming off the life support machine and breathing for himself. This is a good thing.

“Undoubtedly low rates have helped stimulate economic growth. They have made borrowing costs both for corporates and individuals much more affordable; mortgage rates are at historic lows and so is the interest companies are paying on their debts. But this sustained period of ‘easy money’ has also had some insidious effects and one of the victims has been the banks.

“Banks earn money through the difference between the price they charge for their loans and the rate they pay for their deposits. Generally deposit costs can’t move below zero – after all, who would put money in the bank if you had to pay them for the privilege? The result of this has been that bank margins, and therefore profits, have been squeezed hard for years.

“As rates begin to normalise (and that’s what they are doing) bank margins should begin to recover. Higher margins mean higher profits and higher dividends. This is great news for investors. Of course, we will need to keep an eye on bad debts – higher loan prices will inevitably mean higher default levels, but this potential risk should not outweigh the benefits, as long as the increases in yields are steady, which we believe they will be.

“So, in our view, the banks represent an oasis of opportunity in a tumultuous market.”

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