Today I wish to cover several trends of these times as they have all come together in one market. That is the UK Gilt market which is the name for UK government bonds. This is currently being influenced by quite a few factors at once but let me open with the two main factors which brought it to extraordinarily high levels in price terms and low levels in yield terms. The first is illustrated by this from Kenneth Rogoff in the Financial Times.
The mixed results from experiments with negative interest rate policy in Europe and Japan have led many to conclude that the idea is ill begotten and should be abandoned. To do so would be a serious mistake.
As you can see given a choice between reality and the view inside his Ivory Tower he much prefers the latter. This establishment view has driven interest-rates and bond yields lower around much of the world. Added to this in the UK has come the extra £60 billion of QE (Quantitative Easing) purchases of UK Gilts announced by the Bank of England in early August. Today will see it attempt to buy some £1.17 billion of long and ultra long UK Gilts as it buys ones maturing between 2032 and 2068.
A Reversal In Yields
Back in the 12 th of September I pointed out that the benchmark UK ten-year Gilt had a yield which had risen from the 0.5% it had fallen to up to 0.88%. This week it has pushed back up above 1% (1.01% as I type this) which meant that yesterday the Bank of England found itself buying some of our 2023 Gilt at a yield some 0.25% higher than the week before. That is a lot on a yield which was 0.38%! I will be checking later what they pay for our longest dated Gilt and how that compares to the 198 they have paid to get a scale of a program which in its recent incarnation is running at a marked to market loss.
If we look for the yield most relevant to fiscal policy the thirty-year has risen to 1.7% (low 1.19%) and for fixed-rate mortgages the five-year has risen to 0.4% from a low of 0.12%.
What has caused this?
Markets seem to have suddenly realised that inflation is going to go higher as this from the Financial Times indicates.
As a result, market expectations of UK inflation measured by the five-year break-even swap rate have jumped to 3.6 per cent — the highest level since early 2013.
Regular readers will be aware that I was expecting a rise in UK inflation as 2016 heads to a close anyway and it would have been enough to make even the new five-year yield look silly in real terms. It would also question the ten and thirty year yields. Now if we add to this the extra 1.5% of annual inflation I expect as the impact of the lower UK Pound £ then even the new higher yields look rather crackpot. Over as far ahead as we can see then we are expecting inflation adjusted or real yields to be strongly negative. Accordingly the UK Gilt market has been singing along to the Nutty Boys.
Madness, madness, they call it madness
Madness, madness, they call it madness
I’m about to explain
A-That someone is losing their brain
Why have they done this? This is another theme of these times as they are simply front-running the Monday, Tuesday and Wednesday purchases of the Bank of England. This manipulation of the market by it means that all the old rules for pricing Gilts have been both broken and ignore or if we are less polite a false market has been created.
The impression that the UK government will loosen fiscal policy has gained ground and this has two components. The first is that it seems likely to spend more than the previous administration in a like for like comparison and secondly there is the impact of releases like this from the UK Treasury. This has had an impact today although it is in fact the same one released several months ago.
Cabinet ministers are being warned that the Treasury could lose up to £66 billion a year in tax revenues under a “hard Brexit”, according to leaked government papers.
GDP could fall by as much as 9.5 per cent if Britain leaves the single market and has to rely on World Trade Organisation rules for trading with the continent, compared with if it stayed within the EU, the forecasts show.
So those with short memories will be made nervous by the “scoop” in the Times. I do not know if the expected 18% fall in house prices is still in it as well.
The wider picture
We are seeing a global move towards higher yields and as an example we even now have a positive yield for ten-year German bunds albeit one of a mere 0.06%. The US 10 year Treasury yield has risen to 1.76% on the back of stories like this from Bloomberg.
Pacific Investment Management Co. says the Federal Reserve may raise interest rates two or three times by the end of 2017. Treasuries tumbled after oil prices rose.
Are those the ones that have not taken place so far in 2016? Also it is hard not to have a wry smile at the statement by Pimco that UK Gilts were on a “bed of nitroglycerine” which preceded one of the strongest rallies in history.
Not everybody is upset by this
If we move to the world of pension deficits then quite a few UK companies may welcome higher Gilt yields. This has been illustrated by this news today from Pensions World.
The aggregate deficit of the 5,945 schemes in the Pension Protection Fund (PPF) 7800 Index has decreased to £419.7bn at the end of September 2016, from a deficit of £459.4bn at the end of August 2016.
So £40 billion less to find which even in these inflated times is still a tidy sum. For those of you who would like to know the total sums at play, here they are.
Total assets were £1,449.5bn and total liabilities were £1,869.3bn. There were 4,993 schemes in deficit and 952 schemes in surplus.
Let us take a dose of perspective. If I look back over my career I can recall longer Gilt yields being 15% and more so 1.7% remains extraordinarily low and we should take advantage of it if only to improve the cost of our stock of Gilts. On that basis the recent rise is small but it also shows that we should not dilly and dally forever as events move on.
However there is another case of a false market here and it is one created in inflation-linked Gilts. They should be rising as inflation forecasts rise but whilst they are not part of the QE program their price has been driven higher by it as they are closely linked to ordinary or conventional Gilts. So we face the prospect of another false market as it is possible that higher inflation could be accompanied by lower prices for index-linked Gilts. Mind you I see that the new boy at the Bank of England is getting in his excuses early. From @LiveSquawk.
BoE’s Saunders: Expects MPC To Tolerate Modest Currency-Driven Inflation Overshoot In Next 2-3 Years
I wonder what “modest” is?
BoE’s Saunders: Expects GBP Weakness To Lift Inflation ‘Quite Substantially’
Oh and we see a clear sign of one of Carney’s cronies as we see a breathtaking attempt to shift the blame for the consequences of QE.
Saunders: Government Has Many More Tools To Resolve Distributional Effects Of Monetary Policy Than BoE