Surprise inflation data has sent bond markets into a tailspin with the British economy now expected to be shrinking by the end of the year.
Borrowers had been crossing their fingers that the relentless march of interest rates upwards was over, but that hope has now been dashed.
Higher interest rates – the Bank Rate is now expected to peak at 5.5pc – and the looming threat of recession have big consequences for savers, borrowers and investors.
Why have bond markets been thrown into turmoil?
Despite inflation falling overall to 8.7pc in April, according to ONS data published this week, prices are still rising above the Bank of England's 8.4pc forecast.
More worryingly, core inflation – a measure of domestic price changes – increased to 6.8pc in April, its highest level since 1992. Markets don’t respond well to shocks, which is why the Government’s borrowing costs have started surging.
Chancellor Jeremy Hunt now appears to have resigned himself and the country to the fact that Britain will follow Germany into a recession as a result of attempts to bring inflation under control.
Pensioners: sit tight and consider annuities
Final salary or "defined benefit" pensions are unaffected by market movements and payments are pegged to inflation (though are often capped at 5pc a year in the private sector).
Today most people have defined contribution schemes, where pensions are invested in the stock market. So far, the effect on the FSTE 100 index of the biggest London-listed companies has been muted.
There is no reason for pension savers to panic, but, as always, it is important to limit withdrawals to what you need in the short-term.
Taking money out of a pension while markets are depressed is a poor strategy as you miss out on any future stock price recovery and your money loses value when left in cash.
One financial product that does gain from rising interest rates are annuities. Now largely out of favour, these insurance contracts are priced largely on life expectancy data and the yield on government bonds, or "gilts".
Annuity rates have risen considerably over the past two days. A 65-year-old with £100,000 can currently buy an annual, single life annuity income of £7,240.
Annuities last reached these levels late last year and are at highs not seen for more than a decade. At the start of 2022, the average rate was around 5.1pc. But now, retirees can get over 7pc. That’s around £2,000 or more a year, per £100,000.
Mark Ormston, a director at annuity brokerage Retirement Line, said: “Where else can people get 7pc returns and more, guaranteed for life?”
In the thick of a cost-of-living crisis, many pensioners on fixed incomes have already slashed their energy consumption and cut down on inessential expenditure. Now, it might be time for this cohort to look at ways to make their pension pots go further.
Andrew Tully, of pension provider Canada Life, described it as “a balancing act” between taking income to support increased costs now and trying to make sure a pension pot lasts throughout your lifetime.
He added: “For those people already in drawdown, investment strategies and retirement plans will have factored in certain assumptions around income needs, but it takes bravery to stay the course.
“Diversification is key, as is the ability within any financial plan to flex between income sources where possible.”
Pension holders invested in a range of asset classes will be the most shielded from the ravages of inflation, he explained, and those with an income strategy which minimises tax will be doubly insulated.
For those still working, Mr Tully expected people to cut back on their pension savings as wages have to stretch further to cover rising costs.
On the flipside, he said there could also be a rise in over-55s returning to employment after retiring early during the pandemic but who now realise they can't afford not to work.
Savers: lock in high rates and hope inflation comes down
High inflation can be good news for savers, as long as you secure the best rates. With the Bank Rate now expected to 5.5pc, interest rates on savings will only climb higher, earning people greater returns.
Currently, Shawbrook is offering the highest one-year fixed-term bond at 5.06pc, and on Thursday Investec launched a two-year fixed-term bond paying 5.15pc. But bonds spanning longer than two years are closer to 5pc.
Anna Bowes, co-founder at data firm Savings Champion, said interest rates on variable savings accounts are likely to rise following the latest inflation figures, in line with fixed-term bonds.
While fixed-term bonds are priced with future market expectations in mind, variable savings accounts react to the Base Rate.
Ms Bowes said: “What is interesting is that shorter-term fixed-rates are paying the same or more than longer term bonds. That’s unusual. Markets are expecting that once the Bank Rate does peak it will come down a little bit, but not to the levels we’ve seen in recent years.
“That gives people an opportunity. Cash won’t beat current inflation, which is running at 8.7pc, but the more you earn in interest, the more you can mitigate the effects of inflation.”
If inflation does fall back to 2pc by the end of 2024 or by the beginning of 2025, as the Bank of England is hoping it will, then locking into a high rate for the next five years could be “a very shrewd move”, Ms Bowes said.
Investors: pick strong brands with pricing power
So far, high inflation has not tipped the UK into a recession. But investors are nervous with a watchful eye on the US.
America hit its $31.3 trillion debt limit in January, and since then its top tier credit ratings have come under pressure as the country’s government edges ever closer to running out of money.
The US market tends to dictate markets globally. Charlie Huggins, a portfolio manager at investment service Wealth Club, said fears around US debt ceiling negotiations have weighed on markets.
He explained: “We’ve seen it in the past. It usually blows over. But for now, investors are watching the Federal Reserve very closely to see if it raises America’s Bank Rate.”
Rising interest rates can mean investors cut back as they need to meet the higher cost of servicing debts.
Mr Huggins said investors will want to see some pricing power in businesses they are investing in, and should be wary of firms unable to raise their prices.
Businesses providing essential or critical services are a good bet, he said, as well as those in a strong, market-dominant position. “Firms will struggle to increase their prices if there’s lots of competition,” he said.
Companies like pest control firm Rentokil, which consumers cannot cut back on even in a recession, and which have a strong brand are a good bet, he recommended.
If a recession does happen in the UK, Mr Huggins said it will be a double-edged sword. It would see interest rates come down with inflation, as people fear for their jobs and are put off asking for pay rises.
But on the other hand, a recession is never good for company earnings because consumers spend less.
Mr Huggins explained: “A mild global recession might be the goldilocks scenario, where interest rates come down but it's manageable enough that company profits stay flat. A worst case scenario is of course a major global recession where company profits plummet.”
Currently, increases in food prices remain stubbornly high and unemployment is low which is helping workers to demand higher wages, said Jamie Smith, a financial adviser at Foster Denovo.
He added: “This feeds into the inflation loop, as higher labour costs tend to get passed on in the price of goods and services.”
Homeowners: mortgages 'are definitely increasing'
Over the next three months, brokers reckon mortgage rates could shoot up as much as 0.75 percentage points. Major lender Nationwide raised its mortgage interest rates by as much as 0.45 points on Friday, while others have pulled all their products in an effort to reprice them.
The average two-year fixed rate has now reached 5.35pc and the average five-year fixed rate is now 5.02pc, according to Moneyfacts.
Mortgages are priced on "swap" rates and gilt yields which have both been on the rise recently.
Richard Bishop, managing director at advice firm PFEP Wealth Management, said the US debt ceiling is intrinsically linked to gilt yields right now.
He explained: “Gilt yields have gone from 4.2pc to around 4.35pc. The market wants more value for lending to the US government, because of the heightened risk it could default. This is pushing up prices of short-term borrowing for governments, including the UK.”
In the short to medium term, however, this could work in borrowers’ favours. Mr Bishop said a lot of lenders will need to remain competitive if they want to make the cash they have collected work.
He said: “They don’t want to buy gilts, because they’ll have to hedge them. Because the gilt market is volatile, they could make a loss. So even if rates move up to 5.5pc and more, this might not be reflected in the market. They’ll still want to be competitive.”
The Bank of England getting its inflation predictions wrong this week by as much as 0.3 percentage points has also pushed up mortgage rates.
Now Mr Bishop reckons markets are pricing in up to 0.50 points over the next quarter. “Mortgages are definitely going to be increasing. We could see rates rise as much as 75bps over the next three months.”
Brokers are locking in rates for borrowers with maturing mortgages a full six months in advance of their rate running out.
Chris Sykes, director at brokerage Private Finance, said he is also looking on behalf of clients into whether it’s worth them making overpayments with their savings.
Lenders have been upping the amounts borrowers can repay in recent months, with NatWest increasing its annual overpayment allowance from 10pc to 20pc.
For those buying, Mr Sykes is recommending getting qualified for finance nice and early, before falling in love with any properties.
He explained: “This at least gives buyers a guide of what is feasible, as mortgage rates are quite volatile at the moment. With rents increasing and now less scary comments coming out about house price crashes, buying for many first-time buyers is still an attractive thing to do.”