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.
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…).
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.
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.
#gilt 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?