The problematic nature of current bond yields

One of the features of the credit crunch era has been the falls in first world interest-rates and bond yields. The first phase saw the slashing of official short-term interest-rates and once that was seen to be inadequate, central banks directly purchased bonds to reduce yields further. It is seldom put like this but there was already an implied failure as according to the models back then the interest-rate cuts should have done the trick. Back then I was already looking ahead to when there would have to be ch-ch-changes and posted the view that central banks would delay what has become called policy normalisation.

For example back on the 24th of February 2011 I pointed out this about a speech from David Miles of the Bank of England.

 My problem with this is that when you act as they have and you have in effect used what weapons the Bank of England has virtually to the maximum by cutting interest-rates by 4.75%% and spending some £200 billion on asset purchases then you have been extraordinarily interventionist. Accordingly it is then hard for you to blame events because some of them are the consequence of your own actions……

What that illustrates is that already the truth was being manipulated and also I am glad I wrote “virtually to the maximum” as of course the amount of asset purchases has more than doubled. In addition we have seen credit easing in the UK via such policies as the Term Funding Scheme and the start of full-scale QE from the European Central Bank as well as negative interest-rates.

But the point about delaying proved to be very accurate as the Euro area is still actively pursuing QE and in net terms the UK has managed to raise interest-rates by a measly 0.25%. The opportunity in 2014/15 was meant with promises via Forward Guidance but no action.

The US

This is the one country which has taken clear action on the path to normalisation. Here is the current state of play.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent.

That is currently working out be be around 2.2% and more rises are promised. Also there is some reversing of the QE or Qualitative Tightening.

The Committee directs the Desk to continue
rolling over at auction the amount of principal
payments from the Federal Reserve’s holdings
of Treasury securities maturing during each
calendar month that exceeds $30 billion, and to
continue reinvesting in agency mortgage-backed
securities the amount of principal
payments from the Federal Reserve’s holdings
of agency debt and agency mortgage-backed
securities received during each calendar month
that exceeds $20 billion.

That combined with forecasts of another interest-rate rise in a fortnight and at least a couple next year seemed to put pressure on bond markets. However this sentence in a speech from Federal Reserve Chair Jerome Powell shook things up on the 28th of last month and the emphasis is mine.

We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.

You may note we seem to have travelled from “policy normalisation” to neutral. But what the neutral interest-rate represents is an attempt to figure out what interest-rate would neither stimulate or contract the economy. Or a sort of measure of what we might aim for as a new normal. When they are trying to put a pseudo scientific gloss on things economist and central bankers call it r-squared.

However the “just below” dropped the expected path for US interest-rates by 0.5%.

Bond Markets

Let me take you to the Wall Street Journal on Tuesday.

This quarter, yields on longer-dated bonds have dropped and those on two-year Treasurys are flat. The gap between two and 10-year Treasury yields is now around 0.11 percentage point, compared with around 0.55 percentage point at the beginning of the year.

This is attracting a lot of attention in the financial media but the change of 0.44% is pretty much my 0.5% suggestion above. Now let us look at the US ten-year yield which is 2.9% as I type this and we see that in basic terms it is predicting a couple more 0.25% interest-rate rises. This will come in the next year or so if true so it is not very different to the two-year yield of 2.76%.

If we look beyond Federal Reserve policy we have seen a fall in the price of oil over the past month or two. If we look at it in Brent Crude terms then just above US $86 of early October has been replaced by below US $59 this morning as oil follows equity markets lower. The exact amount of the change varies but the path for inflation now seems set to be lower as it has been rare in 2018 for the oil price to be below where it was this time last year. That is another reason for lower bond yields.

Is this a signal of a recession? Here is the St.Louis Fed from last week.

Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased.

That is a fascinating way of looking at it and in my experience precisely zero bond market participants will look at it like that. It is also revealing that we seem to just assume growth will now be lower. Didn’t they save us?

Comment

I wanted to look at this subject today because of the clear changes which are happening. Now it looks much less likely that US interest-rates will pass 3% and if they do not by much. So “normalisation” will be at best about two-thirds of what it might have been considered to be pre credit crunch ( 4.5%). Some of you have suggested that we can no longer afford interest-rates and yields above 3% so well done at least if we stay where we are! If Italy folds you may get a second tick in that box.

But as we look wider we see even more extraordinary developments. Let me take a look at my own country the UK which is in political disarray yet the ten-year Gilt yield is below 1.3%. So those predicting a surge in Gilt yields are slipping back into the bushes whilst I note the extraordinary absolute level and the persistence of negative real yields which bust past metrics. Germany has a ten-year yield of 0.26% and a five-year one of -0.3% as we note again more metrics which are busted.

So my view is that we cannot rely on old recession metrics because another cause of all of this is that QE4 from the US Fed has got closer. I have worried all along that interest-rate rises might run into more QE and if they do we will be singing along to Coldplay.

Oh no I see
A spider web and it’s me in the middle
So I twist and turn
Here am I in my little bubble

 

 

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What has been the economic impact of Bank of England QE?

Whilst the casual observer might think that the QE era is over in fact it is alive and kicking with the Bank of England in action again this afternoon.

Date of operation 26/03/18
Total size of operation Stg 1,220mn
Stocks offered for purchase
UKT_3.75_070921
UKT_4_070322
UKT_0.5_220722
UKT_1.75_070922
UKT_0.75_220723
UKT_2.25_070923
UKT_2.75_070924

This is part of what has become called an Operation Twist style manouevre where maturing bonds held by the Bank of England are reinvested in the market. It is in fact an expansion of the policy not so much today as relatively short-term Gilts are purchased but tomorrow it will stretch out to 2065 as longer maturities join the party. Also if you look at the third Gilt on the list there is a reminder of when the August 2016 Sledgehammer QE launched a kamikaze style assault on the Gilt market and the ten-year yield fell to 0.5%. Of course it was not a ten-year itself but it was a child of those times as I mull whether we will see its like again?

The answer to that question is not without another surge of buying from the Bank of England which brings us to an economic benefit from the current QE. It is that it allows the UK government to borrow more cheaply. This of course has been true of all phases and poses the question of whether this was the real point all along? Initially probably not as the Bank of England struggled to deal with the credit crunch but as time passed as governments got used to borrowing cheaply I am sure there will have been pressure for that to continue. You will have your own thoughts on this. From my perspective I think it is a combination of the Bank of England being nervous on the subject as I discussed on Friday and pressure from the establishment. After all how often does this get a mention outside of on here?

Without QE the UK government would not be able to borrow at 1.47% for ten years as it can this morning. Quantifying the exact impact is near impossible though as we are impacted by foreign QE purchases as for example Japanese and European buyers would be along if our yield rose. But buying £435 billion out of £1,547 must have had an impact especially as the latter number includes index-linked Gilts which have not be bought.

Corporate Bonds

This is another area which tends to get forgotten. On Friday a Bank of England working paper entered the fray.

As part of its August 2016 policy package, the Bank of England announced a scheme to purchase up to
£10 billion of corporate bonds. Only sterling investment-grade bonds issued by firms making a ‘material’
contribution to the UK economy were eligible to be purchased.

I put in the last bit as there were a lot of questions about some of the companies on the list as this from the Guardian from the 13th of September 2016 highlights.

When the list of eligible companies was published on Monday, one major bond dealer said he was astonished at the names included.

Verizon, a US cell phone network, is on the list, as is another big US telecoms company, AT&T, despite both firms arguably having minimal operations in the UK.

I have pointed out in the past the purchases of the corporate bonds of Maersk the Danish shipping company for which the Danes were no doubt grateful. Indeed Especially grateful as Maersk found stormy waters.

But what about the gains?

These purchases were aimed at stimulating investment activity by lowering corporate bond yields which reduces firms’ borrowing costs and stimulates
new issuance………We find that compared to sterling investment-grade corporate bonds that are
not eligible for the CBPS, the spreads of eligible bonds decreased by about 2-5bps after the announcement of the scheme.

Not much so they had another go.

Compared to corporate bonds denominated in USD, spreads of sterling assets fell by 13.8bps, and compared to
EUR bonds by 13bps after the policy was announced.

We are told that this is the lower bound for the impact ( where have we heard that before?) but unfortunately for the authors the answer is rather similar to the initial foray into private-sector assets by the European Central Bank.

: Beirne et al. (2011) who estimate the effect of the
ECB’s covered bond purchase program (CBPP) that took place between 2009 and 2010. They find that the CBPP lowered euro area covered bond yields by about 12bps.

So the conclusion is that there is not much of an impact at all. Although whilst the Bank of England may think this I am not sure anyone else does.

Because the announcement of the CBPS caught the market by surprise,

After it had promised a “Sledgehammer” I am not sure that anything of that sort could be a surprise. However let us move on with the conclusion that the Bank of England was right in 2012/13 when it made some purchases but then gave up as the impact seems minimal.

What about QE overall?

If we go back to a sort of mainlining QE we have been told this by the Bank of England.

According to the reported estimates of the peak
impact, the £200 billion of QE between March 2009 and
January 2010 is likely to have raised the level of real GDP by 1½% to 2% relative to what might otherwise have happened, and increased annual CPI inflation by ¾ to 1½ percentage points.

As you can see central banking research implicitly assumes that higher inflation is a good thing although oddly post the EU leave vote not so much. But if we look at the level of QE we have now then the economic impact is a bit over double that. Keen to make people individually better off the Bank of England also calculated this.

roughly
£500–£800 per person in aggregate

Updating that brings us to £650 – £1070

Or to put the effect another way.

For comparison, a simple ready-reckoner from the primary forecasting model used by the Bank of England suggests that a cut in Bank Rate of between 250 and 500 basis points would have been required to achieve the same effect.

Personally I think that this is far from the best example as whilst my theory is untested a Bank Rate between -2% and -4.5% would in fact lead to the collapse of the  pension system and torpedo the banks.

Comment

There is a fair bit to consider here. Firstly there is the moral hazard of the research being carried out by the body implementing the policy.. For supporters there must be nagging worry which goes as follows. If it was so good why do we still need it? We continue to make purchases to maintain the stock at £435 billion. In my view the main gainer from that is the government as it can borrow more cheaply. Also the research clearly implies that higher inflation is a good thing when one of the main impacts of the credit crunch both collectively and at the individual level is lower real wages where  inflation is a factor.

Then there is the issue of where the gains from QE went.

By pushing up a range of asset prices, asset purchases have
boosted the value of households’ financial wealth held
outside pension funds, but holdings are heavily skewed with
the top 5% of households holding 40% of these assets.

By definition wealth effects are unlikely to help those hardest hit by the credit crunch. Also Bank of England rhetoric that pensions ( mostly meaning defined benefit ones) were unaffected by this was undermined by its own actions.

It has emerged that employees, led by the Bank’s governor, Mark Carney, received the equivalent of a 50%-plus salary contribution into their pensions last year, underwritten by the taxpayer. ( the Guardian February 2016).

Next is the issue of propping up zombie companies and banks after all wasn’t RBS supposed to be surging into the future some years back?

Will we one day conclude that whilst QE may have had some impacts over time the side-effects build up and eventually would make it a negative.

 

Where does the events of last night leave the UK economy?

That was an extraordinary night as yet again much of the polling industry was completely wrong and the UK electorate turned up quite a few surprises. In fact it was not only the political world which spun on its axis because financial markets had cruised into this election as if asleep as I pointed out only on Wednesday. Against the US Dollar the UK Pound £ had been above US $1.29 for a while and had if anything nudged a little higher. Oh and Wednesday suddenly seems like a lifetime away doesn’t it as we sing along to Frankie Valli and the Four Seasons.

Oh, I felt a rush like a rolling bolt of thunder
Spinning my head around and taking my body under
Oh, what a night (Do do do do do, do do do do)
Oh, what a night (Do do do do do, do do do do)

The Exchange Rate

It was not quite like the EU leave vote night which if you recall saw a sharp rally to US $1.50 before plunging as actual results began to come in. But the UK Pound did drop a couple of cents to US $1.275 in a flash. Since then it has drifted lower and is at US $1.27 as I type this. There was a similar move against the Euro as a bit above 1.15 found itself replaced with 1.135 as Sterling longs ended the night with singed fingers.

This means that UK monetary conditions have loosened again and should the fall in the Pound be sustained then we have just seen the equivalent of a 0.5% Bank Rate cut.

Government Bonds

In spite of the fact that there has been something of a shift in the UK political axis and hence potential changes in the economy and fiscal deficit this market has met such a reality with something of a yawn. The ten-year Gilt yield is currently 1.03% meaning there is zero political risk priced into the market there and if we look at what might happen over the next 2 years an annual return of 0.08% barely covers a toenail of it in my opinion!

What we are seeing her in my opinion is how central banks have neutralised bond markets as a signal of anything with their enormous purchases. In this instance it is the £435 billion of UK Gilt purchases by the Bank of England which seem to have left it becalmed in the face of not only higher political risk but also higher inflation.

FTSE 100

This too fell in response to the exit poll forecasting a hung parliament and quickly dropped around 70 points. However then things changed and a rally started and as I type this it is up nearly 50 points around 7500. Why the change? Well there has been an inverse relationship between the value of the Pound and the FTSE 100 for a while now due to the fact that many of the larger UK companies have operations overseas.

By contrast the UK FTSE 250 has fallen by 0.9% to 19,576 on the basis that it is much more focused on the domestic economy. Again though the moves are small compared to the political shift as we mull yet another implication of the expanded balance sheets of central banks. As I wrote only a few days ago are equity markets allowed to fall these days?

Today’s Data

Production

The numbers here start with some growth albeit not much of it.

In April 2017, total production was estimated to have increased by 0.2% compared with March 2017, due to rises of 2.9% in energy supply and 0.2% in manufacturing.

So better than last month, but once we go to the annual comparison we see a decline has replaced the rise.

Total production output for April 2017 compared with April 2016 decreased by 0.8%, with energy supply providing the largest downward contribution, decreasing by 7.4%.

Those who are familiar with the poor old weather taking the blame may have a wry smile at the fact that of a 0.75% fall some 0.74% was due to lower electricity and gas production presumably otherwise known as warmer weather.

Manufacturing

As you can see above this was up by 0.2% on a monthly basis but was in fact unchanged on a year ago with its index being at 104.5 in both April 2016 and 17. You could claim some growth if you go to a second decimal place but that is way to far into spurious accuracy territory for me.

As we look into the detail we see something familiar which is that the erratic and volatile path of the pharmaceutical industry has been in play one more time.

Within manufacturing, there were increases in 10 of the 13 sub-sectors, but this was offset by the weakness within the volatile pharmaceutical industry, which provided the largest downward contribution, decreasing by 12.2%, the weakest month-on-same month a year ago growth since February 2013.

It has yo-yo’d around for a while now albeit with a rising trend but we will have to wait until next month to see if that continues. However there is of course the issue of what the Markit PMI ( Purchasing Managers Index) told us.

The UK manufacturing PMI sprung back to a three
year high in April after a brief blip in March…….“The British manufacturing industry is moving at
such a pace that suppliers are struggling to keep up
with demand.

The “growth spurt” with a reading of 57.3 does not fit well with an annual flatlining does it?

Trade

Again there was a monthly improvement to be seen.

The UK’s total trade deficit (goods and services) narrowed by £1.8 billion between March and April 2017 to £2.1 billion…….Imports fell across most commodity groups between March and April 2017, the largest of which were mechanical machinery, oil and cars;

This was needed as March was particularly poor leading to bad quarterly data.

Between the 3 months to January 2017 and the 3 months to April 2017, the total trade deficit (goods and services) widened by £1.7 billion to £8.6 billion;

Thus the underlying theme here is of yet more deficits. Maybe not the “thousands of them” of the film Zulu but definitely in the hundreds.

An upgrade of the past

The first quarter saw a couple of minor upgrades as the data filtered through this morning.

The total trade in goods and services balance in Quarter 1 2017 has been revised up by £1.3 billion, to £9.3 billion.

They mean revised up to -£9.3 billion and also there was this.

there has been an upward revision of 0.9 percentage points to growth in total construction output – from 0.2% to 1.1%. The potential upward impact of this revision to the previously published gross domestic product (GDP) is 0.05 percentage points.

Comment

So many areas need a slice of humble pie this morning that a large one needs to be baked to avoid running out. As ever I will avoid individual politics and simply point out that there will be quite a lot of uncertainty ahead although of course if you recall that seemed to actually help Belgium’s economy when it had some 18 months or so of it.

As to the economy this is the difficult patch that I have feared where higher inflation impacts. As usual there is a lot of noise as for example the April manufacturing figure is very different to the Markit  business survey. Also we have the impact of warmer weather on production ( whatever the weather is it gets blamed for something) and more wild swings in the pharmaceutical sector which must represent a measurement issue. Meanwhile as I have pointed out before I have little faith in the official construction series but this rather stands out.

a fall in private housing new work

That fits with neither what we have been promised nor the construction business surveys.

 

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?

The consequences of rising UK Gilt yields on fiscal policy,pensions and mortgages

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?

Inflation

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.

Fiscal Policy

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.

Comment

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

 

 

 

UK Pensions Annuities and Gilt Yields enter an Alice In Wonderland universe

Yesterday there were three pieces of news which in fact were interrelated even though they came from opposing sides of the Atlantic Ocean. Let me present them in chronological order.

The Executive Board of the Riksbank has decided to make monetary policy even more expansionary by cutting the repo rate by 0.15 percentage points to −0.25 per cent and buying government bonds for SEK 30 billion.

 

The (UK) Chancellor has announced that the government will extend its pension freedoms to around 5 million people who have already bought an annuity.

 

(Bloomberg) — Money-market futures traders cut the odds of a Federal Reserve interest-rate increase below 50 percent until December after Chair Janet Yellen lowered her outlook for growth and the pace of policy tightening.

 

These three apparently unrelated moves are in fact part of the trend to lower interest-rates and indeed bond yields that has been evident throughout my career. There have been ebbs and flows but the Status Quo has been this.

Get down deeper and down
Down down deeper and down
Down down deeper and down
Get down deeper and down

 

The Swedish Riksbank seems to have lost what little part of the plot it had retained and cut again against the bankground (background if you prefer) of a strong economy. Then if we move to the US Federal Reserve came a move which regular readers will know I was expecting. It removed the word “patience” from its report but then stepped backwards rather than forwards on the subject of a future interest-rate increase in the United States. One is coming soon or maybe later or maybe not at all as it desperately tries to mimic the boy or rather girl in this instance who cried wolf. Or in terms of Guns and Roses a bit more than a little patience will be required.

Said, woman, take it slow
It’ll work itself out fine
All we need is just a little patience

 

Government Bonds

This is where the link between the UK and US news comes in. As well as the extraordinary drop in the US Dollar ( The UK Pound nearly made US $1.50 as traders were stopped out) there was a surge in US Treasury Bonds. The ten-year Treasury Note shot higher and the yield dropped through 2% to 1.92%. But it a way more important for this discussion we saw the long bond or thirty year rally two whole points as the yield dropped to 2.52%. The yield had been falling anyway as poor economic data continued to appear. Yes this weaker data was continually described as a “surprise” which those of you who have seen my exchanges on twitter with Newsnight economics editor Duncan Weldon may already have noted.

Those who listened to the Budget analysis on Share Radio would have heard me point out that Germany was at an all time high for bond prices and consequently low for yields. As I type this the ten-year yield has fallen to 0.19% according to MTS which is yet another high. Now if we move to the UK we are seeing the pressure build too especially now that the US is moving. Accordingly the UK Gilt market has rallied today and our ten-year yield is 1.55% and more to the point of today’s discussion the 30 year Gilt yields 2.36%. Both are hard to type for someone like me who has so much experience of much higher numbers.

Long-Term Contracts

These have a problem with such low interest-rates. Imagine for a moment an annuity provider in Germany for example looking to offering deals to people 2,5,10 and 30 years into the future. In the first two instances it faces negative bond yields so it would have to offer less than paid in. What a great deal! Moving forwards a 30 year yield on 0.65% offers very little return as the concept begins to implode.

The UK annuity market is not yet at that extreme but with a 30 year yield of 2.36% yields are really rather poor. Or to link matters virtually anyone who has taken out an annuity in the past will have got better terms than they can now. Of course many of them thought that they were getting poor terms! In essence annuity rates are the flip side of falling bond yields.

As an aside final salary pensions just got a little more attractive again or putting it another way we will see less and less of them in future.

Annuity Rates

Many with a pension scheme have found themselves facing this conundrum. From the Pensions Advisory Service.

Over recent years, annuity rates have fallen as we have moved into a low-interest rate environment and annuities have, consequently, become less popular.

 

Add that to an illustration showing you losing 3% per annum as discussed in the comments on here and no wonder pensions sometimes get a bad press!

If you crunch the numbers for a basic (single life no add-ons) annuity at age 65 then it takes around 17 years to get your money back. This is awkward and leads to the view that an annuity is bad value. The government heard the cries of “we would rather keep the money and spend it” and as it mulled the issue no doubt the thought that older people are more likely to vote saw it saw well why not let them?

There are two contrasting views on this. Firstly it frees people up to do what they want with fewer restrictions which is a good thing. However on the same road we see that there is the danger we are borrowing from the future one more time. We are doing that rather a lot these days and for the moment let us ignore the nightmare scenario that the money goes into buy to let investment in the UK property market.

What about existing annuities?

To a government the fact that there are around 5 million annuities must be tempting as of course they are in a population demographic which is likely to vote. They currently are as a group in “profit” as some will have terms vastly better than available now some a lot better and other simply better. No doubt someone somewhere has a loss but this will very much be the minority. Easy money?! Not quite as of course there is another side to the arrangement which is the pension or insurance company which will in generic terms have hedged its position in UK Gilts which will have bought corresponding gains. Oh hang on everybody cannot win! The circle is squared so to speak by the fact that the insurance company is losing on its annuity book compared to current values and prices. It is not even a zero sun game as the pension company will have set out to make a profit so it is in fact a negative sum game.

But our brave establishment knows no bounds in its efforts to borrow from the future or as it puts it give more freedoms! Accordingly we will in 2016 get this.

From April 2016, the government will remove the restrictions on buying and selling existing annuities to allow pensioners to sell the income they receive from their annuity without unwinding the original annuity contract.

 

Hooray so they can take their profit? If you think that please hold your horses and read my explanatory paragraph again. Here is the official version.

it allows the annuity holder to access the value of their property rights where they can find a willing buyer. The annuity provider would continue to pay the annuity payments for the lifetime of the annuity holder, but would reassign those payments to the purchaser.

 

So we are reminded that this is a personal contract dependent on an individual’s life. Time I think for Alice In Wonderland to help us out.

I can’t go back to yesterday because I was a different person then.

 

Why, sometimes I’ve believed as many as six impossible things before breakfast.

 

Putting it in more sophisticated terms perhaps then this reply to making my views known on twitter sums it up. From @NotGiacomo

you don’t think we should trust consumers to correctly price their own derivatives contracts?

 

Comment

Somewhere in this UK establishment version of Alice’s Wonderland the following scenario will play out. Grandad or Grandmother will sell their annuity and take the cash. Then they gift some money to their granddaughter Alice who needs some help to buy a house as she is struggling with her student debt burden. Alice will use the benefit of her university education to figure out that for every £100 she gets from the bank of Grandad/mother she will get another £25 from the UK Taxpayer.

have i gone mad?
im afraid so, but let me tell you something, the best people usually are.

 

If we move back to the pension changes and overlook the dangers of yet another misselling scandal, how many more times are they going to change the rules? I have the formal qualification from the Chartered Insurance Institute but threw away my textbooks the other day. In spite of being recently purchased they are relics of another era.

I wonder if I’ve been changed in the night. Let me think. Was I the same when I got up this morning? I almost think I can remember feeling a little different. But if I’m not the same, the next question is ‘Who in the world am I?’ Ah, that’s the great puzzle!