Let's prepare for rates to rise

The Bank of England in the UK and the Federal Reserve in the US are both edging up interest rates, depressing shares and creating uncertainty, writes Clifford German

Interest rates are on the rise, and the only question in most investors minds is how far they will go and how fast, and how much they will change the prospects for savings and investments. Dollar investors are already expecting America's Federal Reserve to raise rates next month and are diving for cover. The yield on the benchmark US Treasury 30-year bond has risen to 6.35 per cent, sending the current price of the bond to a two-year low, and Alan Greenspan, the Fed chairman, is confirming their worst fears, helping to send the Dow Jones index down, dropping beneath 10,000 at one point to the lowest level since March.

Interest rates are on the rise, and the only question in most investors minds is how far they will go and how fast, and how much they will change the prospects for savings and investments. Dollar investors are already expecting America's Federal Reserve to raise rates next month and are diving for cover. The yield on the benchmark US Treasury 30-year bond has risen to 6.35 per cent, sending the current price of the bond to a two-year low, and Alan Greenspan, the Fed chairman, is confirming their worst fears, helping to send the Dow Jones index down, dropping beneath 10,000 at one point to the lowest level since March.

The UK is going through the same sort of angst. Base rate so far is just a quarter point above the 30-year low earlier this year. But the economy is no longer threatened by immediate recession and the City expects several more rises over the next 12 months. The first is probable next month, especially after Gordon Brown gave the Bank of England (BoE) Monetary Policy Committee members a heavy hint this week he'd support them if they did their duty. Even businessmen, who naturally prefer low interest rates, are ready to admit the BoE is on the right tack, reports this week's Institute of Management survey.

So far mortgage rates have only edged higher with standard variable rates from the Halifax up 0.14 per cent to 6.99 per cent last month, but the best two-year fixed rate up 0.35 per cent and the best five-year fixed up 0.85 per cent over six months ago. Standard variable rates will certainly need to rise further in line with base rate, and borrowers who took out five-year fixed rate mortgages at 8 per cent back in 1996 and were whingeing about paying more than the going variable rate last year are now less worried. The best two-year fixed rate home loans again look attractive at Northern Rock's 5.75 per cent and Abbey National's 6.20 per cent for five years.

Lenders are still competing strongly to lend money to consumers and the cost of personal loans has so far shown no signs of rising. Northern Rock is currently the best buy, says Moneyfacts, charging 7.9 per cent APR if you take out insurance with them, but Nationwide offers un-tied rates of 9.7 per cent over one-to-seven years for amounts over £10,000; Direct Line offers un-tied rates of 9.9 per cent, and Alliance & Leicester will lend upwards of £10,000 at 9.5 per cent if you take out insurance (otherwise 10.9 per cent). The best deal on smaller sums is 7.9 per cent plus insurance at Northern Rock. Credit card rates are also historically low with introductory rates as low as 5.5 per cent and standard rates from 9.9 per cent at Egg and 11.9 per cent at Tesco, but traditional cards are still charging 17 per cent or more if you don't pay off in full each month.

Savers are also doing perceptibly better than they were. Annuity rates which are based on the yield of 15-year gilt edged stocks have edged up over the last nine months, lifting the return expected by a typical man of 65 investing a £10,000 pension fund, from under 8.8 per cent earlier this year to just under 9.2 per cent today according to specialist advisers Annuity Direct. Selected savings rates have also begun to creep up. Rates paid on cash mini-ISAs haven't changed since their launch last April. The top rate of 6.55 per cent on a CAT-marked cash ISA is from Coventry BS, just topping Nationwide's 6.5 per cent.

Deposit rates are edging higher, but many banks and building society are only offering the better rates on selected accounts that are cheap to run, like the Co-op Bank's new Smile account paying 4 per cent on current account credit balances, and Northern Rock's base rate tracker currently paying 6.25 per cent on £1,000 upwards in post and phone accessed accounts,

National Savings rates are creeping higher. The new 53rd issue savings certificates were launched this week, paying 4.3 per cent net over five years against 3.85 per cent on the previous issue. Income bond rates rise next week and the prize fund on Premium Bonds will go up from 3.25 to 3.5 per cent in January. The best two-year fixed rate savings bond from Chelsea Building Society currently pays 7.05 per cent, 0.8 per cent above the best buy six months ago, Returns on new Guaranteed Income Bonds have also moved about 1 per cent higher over the last six months, with best buy AIG Life currently paying 5.25 per cent for two years and 5.40 per cent for three years, both net for standard rate taxpayers, on £5,000 upwards.

Yields on stocks and bonds have also risen but the downside is that prices have fallen significantly. The yield on a ten-year bond has risen from 4.6 per cent at the end of April to 5.7 this week. War Loan, the star performer in the rising gilt markets in recent years, has gone into reverse, falling from an £80 high for £100 nominal of stock to about £68 now.

Stock markets are also past their peak, almost entirely driven by interest rate fears. The FTSE100 was down 12 per cent earlier this week from its all-time high in May and the yield had risen from 2.4 per cent to 3.2 per cent. The key question remains how far interest rate rises will go and how it'll affect savers and borrowers. Much depends on how far confidence, that most unmeasurable of economic factors, will be affected.

It is still possible to find doomsters, but fund managers and analysts are still optimistic. Jeremy Batstone of Natwest Stockbrokers says UK base rates will peak next year at some 6.25 per cent; economies will go on growing, and markets will soon recover their poise.

Batstone thinks that, even if the top 100 shares stall, there's value to be found, especially in defensive stocks such as utilities and brewers, tobacco and pharmaceuticals, and later in financials, telecoms and technology. Dresdner Kleinwort Benson mid-cap unit trust manager Derek Lygo claims the mid-cap sector, that's already outrun the FTSE 100 this year with strongly performing IT and media stocks, should continue outperforming the Footsie.