UK interest rates hit 4%: what to expect for stocks, bonds and mortgages

The latest interest rate rise is good news for savers but not so great for mortgage holders. We examine the impact on stocks, bonds, savings and borrowing.

Today the Bank of England raised interest rates to 4%, their highest level since the credit crunch in 2008. The monetary policy committee (MPC) voted by a majority of 7–2 to increase the bank rate by 0.5% to 4%. The two dissenting members voted to maintain rates at 3.5%.

The MPC now expects the base rate to rise to around 4.5% and fall back to 3.25% in three years’ time, although the committee comments that, “there are considerable uncertainties around this medium-term outlook, and the committee continues to judge that the risks to inflation are skewed significantly to the upside”.

• Invest with ii: Open a Stocks & Shares ISA | ISA Investment Ideas | Transfer a Stocks & Shares ISA

Headline CPI inflation has proved more persistent than the Bank had hoped. Although inflation “has begun to edge back and is likely to fall sharply over the rest of the year...the labour market remains tight and domestic price and wage pressures have been stronger than expected, suggesting risks of greater persistence in underlying inflation”.

The Bank’s warning that inflation could remain raised suggests it's highly unlikely we'll see a return to super-low interest rates any time soon.

Two economic scenarios

Since the MPC last met in December, market expectations of a recession have softened and most experts are now predicting lower long-term inflation and a shallower recession.

The MPC comments that, “there had been a further reduction in financial market participants’ near-term inflation expectations since the MPC’s December meeting, in part reflecting falls in wholesale gas prices. In the United Kingdom, the median of MaPS respondents’ expectations for CPI inflation one and two years ahead had fallen to 3.5% and 2.5% respectively, compared to 5.5% and 3.0% in the previous survey in December".

But a smaller group of experts argue that we could be in for a period of higher and more unpredictable inflation. Speaking to interactive investor's collectives editor Kyle Caldwell, Ruffer Investment Company (LSE:RICA) fund manager Duncan MacInnes said “the last decade had 2% inflation with very little volatility around that. The next decade might have 3% or 4% inflation on average, but with 10% inflation like today and some periods of lower inflation, zero inflation or deflation.”

• Seven times the experts got it very wrong on the economy

If inflation falls sharply and there is a deeper-than-expected recession, there’s a risk of a “whiplash pivot” as central banks reduce rates to boost the economy.

Impact on stocks and bonds

The stock market has enjoyed a mini rally in recent months, as fears of a long and hard recession recede. In the autumn, the stock and bond market had already priced in rate rises this year, so stock prices improved as rosier economic expectations emerged.

However, if inflation defies predictions, as MacInnes fears, central banks may be forced to further tighten rates, with a potential knock-on impact on stock prices. Interest rate rises particularly affect growth stocks as they are used to price future profits: those profits are discounted to work out today's value using interest rates. 

• 10 shares to give you a £10,000 annual income in 2023
• Inflation to remain high for 10 years: what does it mean for investors?
• Is now a good time to start considering smaller companies?

The potential uncertainty is an important reminder to match your investment strategy to your time horizon. If you’re investing for the short term, then it may pay to adopt a more defensive strategy. In contrast, long-term investors can better afford to ride out the ups and downs of the stock market, so may decide to go all in on the stock market.

For bond investors, yields still look attractive. Sam Benstead, deputy collectives editor at interactive investor, says that, “with inflation still at double digits in the UK, but falling slowly, investors will struggle to get an inflation-beating income. But there are plenty of options in the bond market that provide respectable returns without many of the risks of the stock market, and if inflation falls back to the 2% target, then real returns will become more attractive.”

Impact on mortgage holders

Interest rate rises hit British homeowners harder than our continental cousins, due to the popularity of short fixed-rate mortgage deals and the boom in house prices in recent years. According to Myron Jobson, senior personal finance analyst at interactive investor, there are tough days ahead. He comments that: “Official figures show that almost 725,000 fixed-rate mortgage deals are coming to an end in the first half of this year.”

• Will overpaying my mortgage or pension make me richer?
• UK housing most unaffordable since Victorian times

Those nearing the end of their mortgage deal are in a bind, with an estimated 80% of UK borrowers currently on rates of 2.5%. “Fix now or fix later is the dilemma facing those approaching the end of their fixed-rate mortgage deal in the coming months,” comments Jobson.

He believes that: “those approaching the end of their mortgage deals could benefit from being proactive in seeking the best deals now to have more options on the table further down the line. All mortgage offers are valid for a fixed amount of time. Typically, they will last between three and six months, depending on the lender. You are not tied to mortgage contracts until you sign on the dotted lines, so you can ditch it if you find a better deal in the interim.”

It's a more complicated picture for first-time buyers as house prices begin to fall, but mortgage costs increase. Rachel Springall, finance expert at Moneyfacts.co.uk, says that: “First-time buyers with a limited deposit may put their plans on hold until they can more comfortably afford to take out a mortgage.”

Impact on savers

For savers, things are gradually improving, although banks are often slow to pass on interest rate rises. Jobson says: “it could take months for the increase in interest rates to trickle through to savers – if at all. The acceleration in the frequency of rate rises has meant that some savings providers may still be catching up to past base rate rises”.

Springall says: “Interest rates on variable savings accounts are continuing to rise, as several providers have improved their offers since the start of 2023. The influence of the Bank of England base rate rises, along with rate competition, has made a positive impact on variable rate savings accounts, which include Cash ISAs.”

• Cash is not king: what falling inflation will mean for investors in 2023

But savers may need to look beyond the well-known names to get the best rates. “Challenger banks and building societies continue to take the most prominent positions in the top-rate tables, so savers who fail to review their existing account to the latest top rates may miss out. Loyalty does not always pay and the majority of the biggest high street banks have failed to pass every Bank of England base rate rise to easy access accounts, with two brands passing on just 0.54% since December 2021.”