Is there a crisis building in the UK Gilt market?

The period post the UK EU leave vote has led to some powerful moves in financial markets of which the clearest has been the fall in the value of the UK Pound £. However the last few days have seen some declines in the UK Gilt (sovereign bond) market which have unsettled some of the media and the Financial Times in particular. From Friday.

Britain’s benchmark 10-year bond yield is soaring today, rising 0.17 percentage points to 1.143 per cent – its highest since the Brexit vote and a sell-off that is far worse that its developed word rivals. The leap is the single biggest daily climb since April, according to data from Bloomberg.

Biggest daily climb since April, should we be cowering in our boots then? Over the years I have seen a lot of Gilt market sell-offs and noted that many big moves take place on a Friday afternoon. As there are fewer end of week liquid lunches these days such moves can often be put down to a different type of lack of liquidity. The actual issue is much more complex than the Great British sell-off line being plugged.

Inflation Inflation Inflation

Back on the 14th of June I pointed out that there was a building problem for the UK Gilt market.

There is much to consider as we note that inflation expectations and bond yields are two trains running in opposite directions on the same track. The exact path of inflation is unknown as we do not know what oil prices will do but we do know they will have to continue to fall for inflation to stay where it is. Also as someone who questions official inflation measures I would point out that even the UK 30 year Gilt is now offering no real yield at all on current expectations and looks set to go negative.

Thus the UK Gilt market looked expensive even back then as I noted that inflation was on course to head higher. Only last week on the 11th I returned to this same subject.

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.

I gave a lyrical accompaniment to the situation from Madness.

Madness, madness, they call it madness
Madness, madness, they call it madness
I’m about to explain
A-That someone is losing their brain

The problem for UK Gilt prices and yields is that they look on a different planet to the one where the official measure of inflation is heading towards 3% and the RPI (Retail Price Index) is heading towards 4%.

The Bank of England causes instability

The way that Governor Mark Carney and the Bank of England rushed to promise a “sledgehammer” of monetary easing post the EU leave vote saw the Gilt market soar. This was one of the worst cases of miss pricing I have seen as at the same time rising inflation expectations meant that the Gilt market should be falling. As well as an announcement of £60 billion of extra Gilt purchases via a new burst of QE (Quantitative Easing) there were hints/promises of “more,more,more”.

by expanding the scale or variety of asset purchases.

The markets simply front-ran the expected purchases and the ten-year Gilt yield headed for but did not quite reach 0.5%. At this level it was completely mispriced compared to inflation expectations and as it happens in meant that the inflation expectations market was completed mispriced as well as they were giving higher coupons which investors were desperate for. Quite a mess!

Now with the UK Pound £ lower the Bank of England is reining back on its Forward Guidance Mark 25. Ben Broadbent has been on Radio 4 doing exactly that today. From Bloomberg.

“Having a flexible currency is an extremely important thing, especially in an environment when your economy is facing a shock that’s different from your trading partners,” he said in an interview broadcast Monday. “In the shape of the referendum, we’ve had exactly one of those shocks. Allowing the currency to react to that is a very important shock absorber.”

It is a shame he did not think of this before he voted for more easing and gave hints of more to come. Now markets are thinking to themselves that once the current round of Bank of England QE ends who wants to buy Gilts at these levels? I am not surprised that few are to be found with yields a bit over 1% and inflation heading much higher.

Having driven the market up the Bank of England is now pushing it down with Open Mouth Operations. Let us think of that as we read its Mission Statement.

Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability.

What would you do if you were a Gilt investor and saw this on Bloomberg from the Bank of England?

Broadbent said that inflation will probably rise “somewhat” above the goal in the next few years but didn’t indicate any concern about this.

International Trends

A day before it went into panic mode the FT was pointing out that the trend to higher bond yields was international.

Thirty-year gilt yields have jumped 25 basis points so far this month, while US and German equivalent yields are up 21 and 24bp respectively, as prices in long-dated bonds head for one of the steepest monthly falls in a year.

In fact I think it also got the reason why right although there is seldom just one.

Inflation expectations drive the performance of long-dated debt as fixed rate payments are less attractive over time as consumer prices rise.

The other factors to consider are that the US Federal Reserve is yet again hinting at an interest-rate rise and that other forecasts for QE have changed. Do not misunderstand me as the ECB for example is likely to do more QE but for now it wants us to believe that it will not ( so that when it does it can claim a larger impact…).

Fiscal Policy

As well as a reduction in the demand for UK Gilts from the Bank of England there has been the likelihood that there will be more supply as the new government hints at an easier fiscal stance. So again we see a case for lower prices and higher yields.

Comment

The UK long Gilt future is down one point this morning at 125.62 and yields 1.18%. There is an obvious problem with calling something yielding 1.18% a crisis! Let me offer some further perspective as I have followed this market for 30 years now (Eeeek). These 30 years have been a bull market for Gilts and this was added to by the Bank of England ploughing in at what is the highest level it has even been to. If we look at any long-term chart we remain close to all-time highs. You can see that from the Gilt future price being 125 or above 100.

In yield terms 1.18% compares to the above 15% I saw in the past so we get some perspective from that.Oh and about that 1.18% from here on June 14th this year.

UK 10-year yields fall to all time lows of 1.18%

Of course we could cope with nothing like 15% now. If we move to the yield at which one might look for long-term funding which is the thirty year yield we see that it at 1.83% remains very low both in historical terms and compared to likely inflation.

I note concerns about foreign buyers deserting this market well I can see why anyone would not want to buy it even at these new higher yields! In truth foreign buyers mostly buy for the currency so in fact a lower currency and higher yields may bring some back. Although there is not so much to buy these days as the Bank of England chomps away as the Kaiser Chiefs described.

a powered-up Pacman

The consequence of this can be found in a children’s song as the Bank of England has created this.

The Grand old Duke of York he had ten thousand men
He marched them up to the top of the hill
And he marched them down again.
When they were up, they were up
And when they were down, they were down
And when they were only halfway up
They were neither up nor down.

So we see what is a muddle caused by an overpriced market caused by central bank intervention rather than a crisis. Oh what a tangled web we weave and all that….

As a final point has anybody heard the sighs of relief from the UK annuity and pension industry?

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26 thoughts on “Is there a crisis building in the UK Gilt market?

  1. You can perhaps expect investors to put up with zero-or-negative yields at times of zero-or-negative inflation, but as inflation rises, my feelings are that, although the BoE would like to ignore it, it will find it can’t and may have to raise interest rates…POP!

    • So, how long can the BoE hold out in the face of inflation, how high can the inflation go before rates are pushed up? It seems based on recent ( 5 years ) that they will paper over 3-4% inflation and pretend its good for people, weaning them off foreign imports.

  2. Carney said last week that the BOE would look through any increase in inflation but the question is: will the markets look through the BOE and there has now to be some doubt about that as you have said?

    If market rates are cranking up and continue to do so how long can the BOE ignore this? Its credibility gets less with every day that passes and a true crisis begins to look ever more likely.

    Your remark about pensions may be apposite. If interest rates are indeed forced up then one leg of personal wealth, the property market, will tank immediately. Not only will pensions, the other main leg, take longer to respond (increases in annuity values) but the value of the underlying fund may decline due to falls in the stock market, thus offsetting the boost due to higher gilt yields.

    The net effect is that the population will get a double whammy; lower property values and still rock bottom pension fund values. If they put this all together they will not be pleased.

    • There are significant numbers of people who cant afford to buy and have to rent, who would welcome a drop in property values. At the moment they are renting and adding to the wealth of the speculators.

    • the net effect will be on the “dammed ” banks

      forget the people – we’re just pond life !

      The Banks will feel the cold , they’re too big to fail and too big
      to support

      time to grown some and let them go ……

      ( oi stop that singing ! )

      Forbin

    • Unlikely the Stock market will make a sustained fall given fundamentals as low inflation helps boost profits unless CPI exceeds 3%. Markets start getting nervous when inflation goes over 3%

    • The population will certainly not be pleased, Bob, especially if inflation makes it a triple whammy. But they, not the BoE, will get the blame for voting the wrong way in June.

  3. Great blog, as always, Shaun.
    I watched Ben Broadbent, Carney and the other Bank of England officials in the video of the Future Forum in Birmingham on Friday. One questioner asked why the BoE’s target rate at 2%, and Broadbent responded. What he said was OK as far as it went. He said that the variability of inflation was correlated with its level so if you want stable inflation you want a reasonably low rate. So this told the questioner why the target rate was not 20%, but not why it was 2%.

    I am sure the Deputy Governor responsible for monetary policy is familiar with the history. Chancellor of the Exchequer Gordon Brown set the first point target at 2½% for RPIX, announced in his Mansion House speech from June 1997. The target rate went to 2% in December 2013 when the UK HICP, which has since been called the CPI, became the target indicator. As you have pointed out in several blogs, this amounted to a substantial effective increase in the target rate, since the HICP inflation rate was running so much lower than the RPIX rate. I suspect that Broadbent didn’t go there, because if more British people were aware of the history there might be more calls for a reduction in the target rate.

    It was a great idea to have a forum like this to explain what the Bank of England does to the interested public, but it would have helped if there was a little more candour on the part of the BoE staffers.This wasn’t the only case where they seemed to deliberately withhold pertinent information from the participants.

  4. Shaun,
    Very interesting as usual. I know very little about gilts, but isn’t a 1.1% yield with 2% inflation pretty similar the position in half of Europe, where inflation is say 0.3% and yields -0.75%?
    In other words, people are prepared to “lock in” losses of about 1% a year.

    • so as the result is the same all this MSM chatter is to allow certain amount of speculation on the pound to bump up the profits and bonuses of a few spivs in the city

      same ol’ story ……..

      Forbin

      • I am shocked that you can even think of putting spivs in the same sentence as the city. Don’t you know what is good for you? These people are the lifeblood of our economy, poorly rewarded and groaning under the weight of their bonuses, (sorry, I meant responsibilities)

    • Hi James

      The yields in the Euro area are higher than that so we are set to go more negative in real yield times I think. Mario Draghi will not be pleased. However the catch with this is what inflation rate you use to compare with a 10 year bond for example? As we can look forwards 2 years maybe then there is always plenty of doubt for the other years.

  5. Since 2008, the UK government debt had increased from 560bn, to 1500bn, yet thanks to the very low yields on Gilts, it has actually reduced it’s interest bill, as it has been issuing new Gilts to replace the maturing one’s at much lower rates of interest. In effect they have been behaving like a householder maxed out on his credit cards, frantically switching between lenders, hopping against hope that the music never stops. The game will however be up once yields get above those of maturing Gilts. In 2016 and 2017 maturing Gilts have an average interest rate or around 3%, so at current Gilt prices, the government finances are likely to be okay for a couple of years, however in the event that the current bout of market nerves over inflation expectations turns into an old fashioned Sterling crises, then we could easily see a rise in yields to above 3%. This in turn could just as easily lead to a Greek style funding crises in the UK; as the focus changes to the ability of the Government to ever repay it’s debts. Ultimately they could be left with the choice or default or print, both of which would destroy the value of the pound. and be equally disastrous for residents in a country so dependent on imports. Carnage and his gang at the MPC are playing a very dangerous game in allowing inflation expectations to rise.

    • Hi Mike

      You make an interesting point about 3% Gilt yields being something of a threshold. Let me add another issue which is how high inflation goes because the RPI-linked stocks were 22% of our Gilt stock last time I checked so a rally to 4% annual rate on RPI will soon get expensive in terms of the public finances.

      • Is it not the case though, that the Govt. feels no pain from RPI-linked stocks, regardless of the rate, because the value’s the same?
        So even if the inflation rate was 20%, ~ domestic devaluation of 20%, means that there is no intrinsic increase in value.
        The other 78%, however, devalues rapidly, which is why the Govt. is aiming for inflation above fixed rate bonds.

  6. Shaun, you say a lower currency with higher yields may tempt foreign buyers back in but why would a foreign buyer be tempted back into gilts which are falling in price (although the yield will increase if he buys at the right time) and are priced and yields paid in a currency which is falling against his own native currency as the weeks go by unless he does some serious hedging?

    • Hi Jive Bunny

      As a foreign investor you would not be planning for losses but of course they have happened this summer. But the main play for them is a currency one where they may decide US $1.22 is value and it is certainly cheaper than it was. As to the Gilt market they play it by the maturity of the Gilts they buy. The more worried about it the shorter they go to minimise losses and the more hopeful the longer dated Gilts they will buy to maximise profits. Some major investors used to be trading a lot but I am not sure the market is liquid enough for that these days.

  7. Hi Shaun,

    Great blog as always.

    The $64 question; what will be the trade-off by the BOE between ignoring inflation and gilts, share prices and property all suffering a market correction, when the BOE is finally forced to raise base rates?

    • The question is under what conditions would the BOE raise rates?
      They will not do it to protect the currency
      They will not do it to control inflation

      So when would they?

    • Property rules OK because if that tanks it takes the Banks balance sheets with it and they are sacrosanct to the BOE anyway if to no-one else.

  8. Given that bond markets have been completely distorted by the activities of central banks around the world it’s very difficult for investors to show dissatisfaction with they way things are going. Directly fighting the money printers by shorting bonds has been a sure fire way to lose money. Attacking the currency is really the only option left and it has been clear for a while that a seriously devalued currency is the ultimate alternative to the more honest approach of writing-off unserviceable debts that should have happened in 2008.

    Now you could argue that sterling has already been thumped; if you want to buy a house in London the ‘pound in your pocket’ has halved in value since the financial crisis! However, the BoE doesn’t care about this sort of inflation, in fact they like it and want more. It would be interesting to know at what level of CPI/RPI inflation the BoE would act and how low the pound would have to go to achieve this level. For a short while the BoE could use foreign reserves to defend the pound but that would soon be used up. Then they face the choice between raising rates, killing the housing market, banks and corporate debt bubble, or destroying the value of sterling. I do hope that Carney is still in the hot seat when this happens I would like to see him confronted by the consequences tenure as governor!

    • Going by the history of sterling, the UK authorities would just let the currency fall. Everyone will become a millionaire, but that’s not as great as it sounds when a pint of milk costs a fiver.

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