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August 2011 Commentary

A foggy picture for interest rates 31st August 2011

Fog © Mike Kiev Fotolia #29754348

It will come as no surprise to you to know that I follow what is happening with interest rates pretty closely. But I have been surprised how rates have changed this month.

Over August, 3 month LIBOR has steadily risen from 0.83% at the beginning of the month to 0.88% at 30th August. Whilst 5bps might not sound very much, from March to July it averaged around 0.82%, with a movement of only +/- one basis point. LIBOR is an important rate as the rates banks lend to each other are usually based on it. The three month rate is often used as the reference rate for floating rate bonds and CDs.

Against this backdrop, at the beginning of the month the Bank of England Monetary Policy Committee (MPC) again kept the base rate at 0.5%. It has now been at this level since 5th March 2009: that's 30 months at an all time low. But what was unusual this time was that when the minutes were published on 17th August, they showed that the decision to keep rates unchanged was unanimous. During the rest of 2011, two or three members of the MPC voted for rate increases based on the outlook for inflation. This time concerns over the strength of the recovery had made the "hawks" change their minds. This suggests continued low rates for some time to come.

However, consumer price inflation is still high, hitting 4.4% p.a. in July, which is more than double the Bank of England's target rate of 2%. Add to this new risks to the global financial system driven by the sovereign debt crisis, downgrading of the USA by rating agency Standard and Poor's and the picture for interest rates becomes very foggy.

If we look at what has happened to retail deposit rates over recent months, it seems that some deposit rates have crept up whilst others have been cut back. The graph below shows the average rates paid on new fixed term deposits over the last year for various terms.

Average New Retail Fixed Term Deposit Rates

Graph
Source: Bank of England website, data series CFMBI79, CFMBJ73, CFMBJ72 from August 2010 to July 2011

The trend for short term rates is upwards, one to two year deposits have stayed fairly flat and longer rates have oscillated between 3.4% and almost 4%. Over the last three months there seems to be a downward trend at most terms.

For corporates the picture is one of lower rates all round, with short term rates staying fairly flat around the base rate at 0.5% and term deposits of one year or longer fluctuating between 1.5% and 3%.

Whilst the future path of interest rates is unknown, it is clear that with constantly changing deposit rates, it is important to keep an eye on the rate you are actually earning. And with the financial strength of governments such as the USA under question, it is also important to actively manage your counterparty risk.

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