Friday morning was relatively calm, the UK gilt market was ready for a mini-budget which was to contain an energy price announcement and some tax changes which were likely to result in additional supply of government debt. The promise to households to help them through a tough winter would need to be funded via the issuance of gilts and 10-year yields had risen from 3.1% to around 3.5% through the week leading up to Friday morning.
The mini-budget would be a mini-budget for growth, and the Chancellor indicated it would lead to a 2.5% trend rate of real GDP growth over the medium. There were more tax cuts than had been anticipated which surprised the economics profession and the market, the details of which are well documented elsewhere.
The Debt Management Office was expected to issue around £130bn of government bonds this fiscal year, following the mini-budget gross issuance is now expected to be closer to £190bn and in the following fiscal year, it could be closer to £220bn. Remember, that the price to the government/taxpayer of the energy price cap is open-ended and the ultimate cost of this policy will be dependent on the price of gas in the wholesale markets, this year and next.
That seems significant, even if it stood by itself, and it doesn’t. Aside from the question of whether these measures will indeed create 2.5% real GDP growth over the medium term, the fundamentals do not present an overwhelming attractive proposition for investors buying these new gilts, 25% of the gilt market is held in foreign hands.
Unfunded cuts to government revenue, substantial additional supply into a market which has already had a very challenging year, the Bank of England was due to commence selling gilts back into the market (commonly known as Quantitative Tightening) and of course, very high levels of inflation all against a backdrop of a forecasted imminent recession.
These are just some of the reasons why the gilt market fell on Friday following the Treasury’s announcement, the 10-year yield marched higher closing the day at 4.1%.
Over the weekend market participants digested the news while the Chancellor seemed to double down on the bet, suggesting in interviews further tax cuts would come in due course. Consequently, the selling pressure continued at 0800 on Monday and through Tuesday, with yields on the 10-year gilt reaching 4.5%.
Bond prices are more sensitive to changes in yields if they have a longer maturity, the longest nominal UK bond matures in 2073, the trading price for this bond fell over 30% between Friday morning and Wednesday morning, the inflation linked equivalent also maturing in 2073 has more sensitivity to yield changes due its longer duration, the price of this instrument fell 62% over the same period as yields surged.
It is hard to overstate exactly how extreme these moves are.
The excess volatility and sheer speed with which these yields rose, in what should be a relatively stable market, caused the Bank of England to step in on Wednesday. The pension industry was suffering, and a mismatch between assets and liability opened up quickly, raising margin calls which prompted further gilt sales to fund margin exacerbating the situation. The Bank of England released the break, pausing the QT program, and simultaneously slammed the accelerator and initiated a new unsterilised QE program.
The immediate effect of this action was a rally unlike anything seen in a developed world government bond market. The 2073 nominal gilt rallied 41% that from its lows into the close, the 2073 inflation linked gilt more than doubled in price terms.
Yes, you are right in what you are probably thinking now; QE should, all things being equal, add to inflation, it is stimulative. Adding to the UK’s inflation problem in the same week the Bank of England was due to tighten monetary conditions extends both the government and the Bank of England’s troubles.
Why is the central bank turning 180 degrees and seemingly making the inflation problem worse?
In order to stop the UK government bond market from imploding. Now there appears to be relative calm in the debt markets again attention turns to the currency. Sterling is weak and has sold off aggressively since Friday. A model used by the Bank of England suggests that for every 10% depreciation in the currency (on a trade weighted basis) UK inflation could increase by around 1.5% at the headline level. Conflicting policies are now at the heart of the problems facing the government and the central bank.
How should investors navigate this market?
To my mind, an allocation to very short-term nominal gilts makes a great deal of sense. Avoiding credit spread in what is likely to be a recessionary environment. Yields have risen in anticipation of more rate hikes from the Bank of England, designed to suppress inflation expectations. This does present investors with an income stream which gives the asset class its name back. The short end recommendation means that the bonds will mature in the near future and allow the investor to roll the cash proceeds into another short-term gilt and potentially benefit from an even higher yield. The other asset class which deserves a place in a portfolio is longer dated inflation linked gilts.
Given the recent turmoil, these gilts now offer investors true protection from inflation, real yields (that is the yield available after the effects of inflation) are positive for the first time in a decade. Align a financial liability or a retirement date with the bonds’ maturity and investors can preserve their capital in real terms which means the asset class can be particularly useful in financial planning.