Are deposit rates peaking, and what should you do to optimise returns on cash?

Are deposit rates peaking?

Over the past year, policymakers across the world have relentlessly hiked interest rates in a bid to extinguish inflation. This has catapulted developed market interest rates from levels that were once near zero to multi-decade highs. To compete with market-based rates, many financial institutions in developed markets have eventually raised deposit rates, making deposits a more attractive option for investors.

As global inflation gradually moderates, investors have been looking towards an end to the global rate hike cycle and have begun to anticipate interest rate cuts. While we believe it is reasonable for policymakers to dial back on rate hikes, we think rate cuts might be premature at this juncture. Instead, we believe major central banks will likely hold rates at current elevated levels for an extended period. This means that deposit rates might be peaking, but are in no hurry to fall back to pre-Covid levels.

Why will interest rates stay higher for longer?

In the US, inflation remains persistent and its deceleration towards the 2% target has been slower than expected. On a broader level, the US economy has been more durable to higher rates, with economic growth turning out to be more resilient than expected. This has emboldened policymakers to keep rates elevated without fear of a debilitating economic slowdown. At the same time, we believe policymakers are motivated to avoid any rebound in inflation, especially if it arises from policy errors. The inflation episode from the 1980s serves as a strong reminder for policymakers in their bitter fight against inflation.

In the UK, wage growth has been stronger than expected and has risen to record highs recently, despite signs of a loosening labour market. As wages tend to lag changes in the labour market, strong wage growth today will likely keep inflation sticky in the near term. Meanwhile, core CPI has remained persistently high, driven by a re-acceleration in services inflation. Collectively, recent data underscore the stubbornness of inflation and are likely to give the data-dependent BOE policymakers greater reasons to hold rates higher for longer.

Chart 1: US headline and core inflation

Chart 2: Uk headline and core inflation

What the market is expecting about interest rate going into 2024

With policymakers around the world maintaining their unyieldingly firm hawkish stance, markets have pushed back their expectations of rate cuts and have warmed up to the idea of more rate hikes.

In the US, markets are expecting the Fed to pause interest rates, with at most one more rate hike, for the remainder of 2023.  Markets expect the first rate cut to happen after 1Q24.  Similarly in the UK, markets are also expecting the BOE to pause interest rates, with at most one more rate hike in 2023. Market’s expectation of rate cuts have also been delayed to 2H24.

Why do we prefer shorter-duration securities?

We prefer shorter-duration over longer-duration securities for several reasons. First, shorter-tenor securities offer attractive yields compared to history, following the surge in interest rates in recent years. At the moment, 2-year US Treasuries and UK Gilts are currently yielding around 5.1% and 4.6% respectively. Two years ago, before the respective rate hike cycle, 10-year US Treasuries and UK Gilts were yielding a paltry 1.3% and 0.8% respectively.

Meanwhile, yields of longer-tenor securities have become less attractive as the Treasury yield curve has become deeply inverted. Typically, when the yield curve is normal and un-inverted, longer-duration securities offer higher yields to compensate for the additional risk of holding the asset over a longer period. However, yields of shorter-tenor Treasuries exceed those of longer-tenor Treasuries when the yield curve is inverted. Currently, 10-year US Treasuries and UK Gilts are seeing a lower yield of around 4.3% and 4.4% respectively, as compared to their 2-year counterparts at 5.1% and 4.9%.

Second, we see better risk-reward for shorter-duration securities at the moment. For a start, a higher-for-longer interest rate environment would mean that yields of shorter-duration securities should stay elevated for an extended period, thereby supporting its attractiveness. Additionally, with inflation still persistent in developed markets, we continue to see the risk of rate hikes and hawkish surprises from policymakers. Having a shorter duration exposure can minimise the price downside on a security should interest rates end up moving higher.

If a short-duration focus is warranted, what are the options available to investors?

Investors looking to optimise their returns on cash can consider short-duration bond funds, government securities, bank deposits, or a combination of these options.

Short-duration bond funds, which include collective investment schemes like exchange-traded funds (“ETF”) and unit trusts, offer investors the benefit of holding a diversified exposure to underlying bond issues that have a shorter tenor. These issues may include sovereign, quasi-sovereign, or corporate bonds. Unit trusts are funds run by portfolio managers which offer investors the opportunity to beat the underlying benchmark. That said, these instruments often come with higher costs. On the other hand, ETFs are funds that passively replicate the index performance but are often less costly.

Short-tenor government securities, such as 6-month US Treasuries or 6-month UK Gilts, serve as good low-risk options for investors to park their cash in the short-term. The near-zero risk nature of these instruments comes from the backing of their respective governments. This is helped by the fact that most developed market governments have a strong credit rating.

Bank deposits with a shorter lock-in period are also good low-risk options that are protected by the Financial Services Compensation Scheme, by up to GBP 85,000 for eligible deposits. Not only have deposit rates picked up but a higher-for-longer interest rates environment also suggest that investors have a longer runway to lock in these attractive rates.

Beyond that, bank deposits are a simple, convenient option for investors to optimise their returns on cash – easily accessible through various means, and now even easier with online channels. Unlike investment instruments, bank deposits are also highly suitable for a wider variety of consumers looking to park their cash. For more information on the iFAST Global Bank offerings, check out the product offerings here.