UK Financial Conditions - Pricing in the next phase of risk and accommodation

Nothing lasts forever. And as in similar post-crisis episodes, financial markets in the U.K. appear to have come down to earth. As a result and after a period of extreme accommodation that marked the Brexit turmoil and the economic shutdowns during the pandemic, the RSM UK Financial Conditions Index has taken a quick return to normal. 

Apparently, the Bank of England thought it was time to begin moving past the extreme accommodation phase of monetary policy. It began the process on 16 December with a 15 basis-point rate hike – if you can call it that – while gradually withdrawing support for longer-term bond yields by ending its asset purchases. The Bank thought the policy rate increase to be an appropriate first response to increases in inflation.

More important for the long-term health of the economy and the financial system, we consider these to be the first steps in the normalization of interest rates and the re-introduction of risk into the pricing of financial assets. The financial markets were put on formal notice that monetary policy was entering the let’s-get-back-to-normal stage.

Our index quantifies the degree of risk priced into financial assets. Index values around zero indicate -- by definition -- normal levels of pricing and volatility. Positive levels of the index indicate an accommodative climate conducive for the flow of borrowing and lending. Negative values signify increased perceptions of the potential for default, requiring additional compensation for holders of that risk. 

Seven weeks ago, the RSM index was at its cyclical high. This was the result of central banks flooding the commercial lending market with liquidity at a moment of crisis, while at the same time injecting cash into economies via massive purchases of government bonds that pressured long-term interest rates lower. The consistent guidance of the central banks -- that interest rates would remain low for as long as it took to get the economy back up and running -- facilitated the propensity to borrow and lend.

But that accommodation didn’t disappear overnight. 

Instead, the markets have been anticipating the realignment of monetary and fiscal policy’s support for the economy. As such, the equity market is approaching pre-crisis levels, with rates of return and volatility approaching normal levels. And the pound is doing remarkedly well, considering the disruption to trade, and perhaps because of the success of the U.K. vaccination program relative to their trading partners.

In terms of interest rates, the forward market is anticipating four rate hikes this year, but even so, interest rates will remain extremely low by historical standards for a considerable period of time. The yield on 10-year bond yields has barely breached 1% after suffering through pre-Brexit and health-crisis collapses. What’s more, the inflation-adjusted (real) interest rates remain decidedly negative, meaning that the cost of investment will be repaid in deflated-pound terms. 

It’s difficult to argue that a Bank Rate of 1.25% at the end of the year would be a burden on an economy that is growing. And if bond yields among the developed economies continue to move higher, that would be a sign that the age of austerity has been replaced by investment in innovation and the productivity of the labor force.