Professor Jeremy Batstone-Carr, European Strategist Raymond James Investment Services Ltd
Key Takeaways
After a difficult year, characterised by pronounced volatility, gilt-edged prices are lower and yields higher, back to and even above the levels of last September and the short-lived administration of Elizabeth (Liz) Truss.
The UK sovereign bond market has not suffered alone, global bond markets responding to “sticky” inflation and higher interest rates.
The UK economy has proved resilient up until now, but that may not last as higher interest rates impart downward pressure on activity.
Inflationary pressures are taking longer to subdue than elsewhere, reflected in market pricing. But investors may be being too pessimistic, underestimating the scope for prices to rise and yields to fall going forward.
The gilt-edged market provides both useful portfolio diversification and a typically more stable offset to more volatile stocks.
This has been a difficult twelve months for investors in the UK’s gilt-edged market. Problems began in the early autumn of 2022 at the commencement of the short-lived administration of Elizabeth (Liz) Truss and in particular an unfunded mini-Budget presented by the then Chancellor of the Exchequer, Kwasi Kwarteng. As the wings of crisis beat about the UK economy, manifest on the foreign exchanges as much as the sovereign bond market, desperate times required desperate measures. The Truss-led administration was swiftly replaced, Mr Rishi Sunak assuming the Prime Minister’s mantel and Mr Jeremy Hunt the role of Chancellor. Financial markets breathed a sigh of relief as steady hands took control of the tiller, while the Bank of England stepped in to provide emergency support. So sharp had been the bond sell-off that the market looked a prime target for investors seeking stability against the backdrop of a flagging economy. But after enjoying a brief renaissance the gilt-edged market has sold off again, the benchmark 10-year gilt-edged yield now back at the levels of last September while bonds of a two-year duration have seen yields surpass those mini-Budget highs. Why is this happening?
Perhaps the first point to make is that the UK sovereign bond market is not suffering alone. US Treasury and German bund stock have also witnessed rising yields despite persistent fears regarding the health of Western economies generally. A large part of the justification for the markets’ weakness lies in the persistence of inflationary pressures and the aggressive approach to monetary policy setting deployed by the world’s most important central banks. But while developed markets have been characterised by rising yields, the UK’s gilt-edged market has endured by far the toughest time. This is reflected in the fact that the gap between the UK’s 10-year gilt-edged yield and its US benchmark counterpart is now at its widest level since 2009 while that with the German equivalent is back to levels last seen in 1992.
While the UK economy has surprised many by its ability to withstand the lagging effect of high inflation, rising interest rates and the banking sector’s steady withdrawal of credit to both household and business borrowers, and its oversight drawn praise from international organisations such as the IMF and OECD, it remains very much to be seen as to whether this resilience can be sustained.
One can hardly pick up a newspaper or turn on the radio or television these days without being assailed by a battery of stories of seemingly unending hardship, most latterly the consequence of the sharp increase in mortgage refinance costs. This is a direct consequence of the Bank of England’s single-minded desire aggressively to pursue its primary objective, raising interest rates to drive down inflationary pressure at all costs, even if that means forcing a recession.
Although the Bank insists that price pressures will diminish over time, there’s scant evidence of that happening in Britain. Yes, inflation is on a clearly decelerating trajectory elsewhere, most notably in the United States, but also in China where the year-on-year rate of price increases stands a little over zero and in Europe as the region’s energy supply shock fades. What makes the UK experience so unique? There are two reasons; firstly, energy price inflation has fallen only very slowly, much more so than in the eurozone and thanks to the impact of the UK energy regulator’s price mechanism. Secondly, and much more concerningly for those with responsibility for monetary policy oversight, the UK’s underlying inflation (excluding the impact of fuel, food, beverages and tobacco) has not only proved more “sticky” than elsewhere, it has actually accelerated to a new 31-year high. The justification for this lies, so senior Bank of England officials believe, in the extent to which inflation expectations are now clearly showing up in wage growth. Annual growth in wages has hit 7.2% in the UK, in contrast with 5.2% in the eurozone and 4.3% in the United States. In both latter cases a steadily declining. So UK interest rates have risen and may rise again. In the money markets speculators are betting that a 5% base rate will not be the end of it, with 6% now firmly in the crosshairs.
The way all this relates to the gilt-edged market is through a steady rise in “real” (inflation adjusted) yields. It is clear that investors anticipate both that high inflation will be sustained and that in consequence the bank’s monetary policy stance will have to be higher for longer. But are investors in the UK bond market being too cautious? It is sometimes said that the stock market is populated with optimists and the bond market by pessimists! In the US it is notable that the 10-year benchmark yield has risen only half as far as its UK counterpart. While local issues may account for some of that, the more general point is that investors in that country increasingly believe that higher US interest rates will be effective in forcing inflation down. In Europe, the German “real” yield has risen by even less, revealing even greater confidence in the policy effectiveness of the European Central Bank.
Whilst the UK economy does display notable variance to that of the US or eurozone, we think it likely that the eventual outcome of the Bank of England’s monetary policy setting will be the same as elsewhere, economic weakness and inflation deceleration. Indeed, in a year’s time the latter is thought likely to be pronounced, paving the way for lower interest rates and lower yields in the gilt-edged market. If anything, financial markets, which like to get their worrying in early, are actually underestimating the extent of the eventual fall, a happy ending for investors in what has, up until now, proved a very uncomfortable story.
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