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Cash, the once and future king

Chris Ellinger & Izzi Halewood

Chris Ellinger & Izzi Halewood - Portfolio Manager & Senior Investment Specialist, Fixed Income

This year’s flood of capital into cash investments after a decade of negative returns has been well documented. But using the UK as a case study and looking at forward interest rates suggests cash as king could reign for a while.

Past performance is not a reliable indicator of future returns.

The past decade brought scant returns from investing in cash, but that picture has changed profoundly in the past year. If the ‘higher-for-longer’ mantra over interest rates currently being chanted by central banks plays out, the total return experience for cash investors will look very different for years to come. 

Even if we haven’t reached the peak in rates, we are close. In this context, a look back at the aftermaths of past hiking cycles gives an idea of how total returns compare across different asset types. This week’s Chart Room takes the UK as a case study, looking at the benchmark money market rate, the sterling overnight index average (SONIA), as a proxy for cash and comparing its returns against bonds, the excess return over gilts of the ICE BOA index of all maturity Sterling credit, and stocks (the FTSE 100) following the peak of past rate hike cycles. One thing that’s immediately clear is the consistency of cash returns relative to riskier assets. Aside from a blip in the short-lasted rate rises of 2018, overall cash returns outshine credit returns in the aftermath of a rate rise cycle, while also avoiding the volatility of equities.

In the UK’s case, the current forward curve also tells us that the market is expecting the Bank of England’s (BOE) base rate to remain well above 4 per cent for the next 5 years. As of October 23rd, that rate was expected to be 5.07 per cent in one year, and 4.59 or 4.38 per cent in two or three years respectively. Money market yields track base rates, so higher base rates naturally bolster money market returns. 

Long-end volatility

Much of this also applies to the situation in other cash markets. But of course, there are idiosyncratic factors at play. With peak rates in sight and less uncertainty over changes in monetary policy, there has been a shift of volatility in rates and government bond curves from the front end to the long end. The curve is bear steepening, meaning yields overall are going higher, but it is the long end that is now driving volatility. Traditional UK buyers of long-end paper, such as pensions and liability-driven investment (LDI) schemes, are not coming to the rescue as they are now in restructuring and de-risking mode following the mini-budget crisis in September of last year. 

What’s more, the BOE’s ongoing campaign of quantitative tightening and continuing heavy gilt issuance by the UK government to finance the budget deficit are increasing volatility in longer maturity bonds. Putting all these pieces together leads to higher term premiums, where investors require additional compensation for holding longer duration assets, and therefore bodes less well for that part of the curve. 

Then there’s inflation. While UK inflation has eased and should improve further as the base effects of last year’s big energy price increases dissipate, we are still well above target. If the higher-for-longer narrative plays out, given the elevated volatility elsewhere, the attractive risk-adjusted yields in money markets should make them fertile ground for investors.

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