Tectonic plates move, earthquakes happen
All eyes are on events in the UK gilts market. However, the shifting of the tectonic plates in UK politics, fiscal and monetary policy are matched by pressures building in many other countries, a development which is worrying bodies such as the IMF.
UK bond yields have been volatile this week, ending with a sharp slide lower. They have faced mixed messages from the Bank of England – would the bond purchasing scheme to support pension schemes end today, as indicated by the Governor, or continue in some other form, as hinted by officials? Bond investors have also faced mixed messages from the Truss Government. At the start of the week there would be no change to the ‘go for growth’ agenda, by the end of the week the Chancellor was flying home early from the IMF meetings in Washington – not to discuss with the Prime Minister how to respond to the growing pushback from Conservative MPs but to learn he has been sacked. Political pressures grew too much; the Institute for Fiscal Studies had estimated that the Chancellor needed to find savings of at least £60 billion to shore up confidence in his fiscal plan. Overseas investors are watching with concern rather than mere interest. They hold about 30% of the UK gilts market, so pricing needs to be attractive to encourage them to buy and hold rather than sell. RBC Capital Markets estimate that total public sector debt issuance could reach £300 billion in 2023-24, partly because debt servicing is approaching £50-100bn a year.
Kwasi Kwarteng must have hoped that the news that the OBR report and his fiscal plan will be delivered on October 31st would reassure the financial markets. It might have, but was overtaken by other factors. There is a lack of joined up thinking between the Treasury and the Bank of England –whether economic growth should be faster or slower into 2023. There is a lack of joined up thinking between the Monetary and Financial Policy Committees of the Bank of England – the former wants higher borrowing costs to slow the economy, the latter is concerned that higher bond yields might lead to disorderly financial markets. Observers are uncertain about the FPC’s decisions to support pension schemes. “We suspect the new measures are insufficient and do not fully recognise the long-term nature of the challenges,” said one fund manager. “These measures are probably helpful on the margin, but will not stop what’s going on,” said an executive at one large pension fund. The good news is that there is not a solvency issue facing pension schemes but there may be ongoing liquidity issues – next week will tell more.
Turning back to the MPC, its hawks must be worried by this week’s employment report, which showed the unemployment rate down again to 3.5% and wages growing over 5 1/2% from a year ago. The doves on the MPC will be reassured though that the economy is slowing, with GDP provisionally declining 0.3% in August. The BDO survey of retailers showing sales in September growing at their slowest rate since COVID, whilst a survey conducted by the Institute of Directors found a sharp decline in order books in October. Against this mixed backdrop, the markets are still pricing in an interest rate hike of at least 0.75% and quite likely 1% at the next MPC meeting.
The UK’s situation might be an outlier, but it is not an exception. The IMF took the opportunity of its Annual Meeting in Washington to warn about the risks from higher interest rates. Its economists see the world economy only growing 2.7% next year, about 1% lower than they envisioned in April. The UK and Europe are expected to see almost no growth. The Fund also highlighted emerging market assets, high yielding corporate bonds and real estate as particular assets of concern, suggesting a run on funds could “undermine the stability of the financial system”.
The global backdrop has been unhelpful to the UK market. Data and speeches still suggest that the Federal Reserve will continue to raise interest rates, supporting the strong US dollar. If there is one economic statistic which bond investors pay attention to it is US non-farm payrolls. September’s report showed the unemployment rate dropped back to just 3.5%, its lowest since the early 1970s, with job vacancies exceeding the number of unemployed Americans by more than 4 million. On top of that, September’s inflation report was unpleasant; although lower gasoline prices meant the headline rate slowed to 8.2%, the core rate of inflation reached 6.6%, its highest annual rate since 1982.
The minutes of the Fed’s September meeting emphasized that underreacting to inflation could cause more pain than overreacting. The Governors noted that housing and business investment have started to respond to tighter monetary policy, but not much else. The economy is seen as operating above potential capacity for several years, hence the preference to take rates up and leave them higher for longer. This was backed up by subsequent speeches from such Governors as New York Fed President John Williams: “we need to get interest rates up further and basically get interest rates above where inflation is”. Loretta Mester made it clear that “I do not anticipate any cuts in the fed funds target range next year”. Lael Brainard warned “monetary policy will be restrictive for some time, until there is confidence inflation comes down”. The markets currently anticipate the official interest rate ending 2023 about 4.5%, fully pricing in a move of 0.75% in November and putting a 50-50 weight on the same in December.
The news from Europe also supported higher borrowing costs. German bond yields increased after a media report that German Chancellor Olaf Scholz would support joint issuance of European Union debt to cushion the blow of the energy crisis as long as the money is disbursed as loans rather than grants. A common reaction was more fiscal stimulus will mean more inflationary risks and possibly further rate hikes. In response, Bundesbank President Joachim Nagel said “We must implement our monetary policy robustly. In the foreseeable future, the Euro-system will also have to reduce its bond holdings”. The markets currently expect that the ECB will raise rates by 0.75% in October and the same again by February.
Bloomberg Economics projects that the global average interest rate will rise from 4.7% now to 5.2% by year-end and a peak of 5.4% in 2023. Such a forecast is eminently reasonable, but the very nature of tectonic plates means that slow progress can be interrupted by stress points and then sharp earthquakes – as the news about the Chancellor of the Exchequer demonstrates. Tensions are building within and between governments and central banks, potentially leading to considerable volatility in bond markets in coming days and weeks.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.45 4.20 3.94
UK 3.78 4.15 4.22
Germany 1.89 2.06 2.28
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making