Bad news for some people is good news for others
The adage ‘a week is a short time in politics’ has been much quoted in recent days. The time line is one to go into the history books: within a week, Kwasi Kwarteng left the post of Chancellor, his replacement, Jeremy Hunt, almost completely unravelled the fiscal package announced by his predecessor, and divisions within the Conservative Government forced firstly the Home Secretary and then the Prime Minister to resign.
However, bad news for the Conservatives has meant good news for bond investors, reassured that fiscal discipline will rapidly appear. At the start of the week, investors worried that the Bank of England was ending its support programme. In the event, the volatility was helpful as opposed to unpleasant. On the day of the news that the bulk of the tax cuts announced on 24th September would be abolished, and a firmer fiscal structure be put into place, 30 year gilt yields fell about 0.37% to 4.37% and sterling was up about 1¾% vs the Euro. 30-year real or inflation adjusted bond yields closed down a massive 0.5% at almost 1%. By the end of the week, 10 year gilt yields were back below 4%, whilst 30 year gilt yields had fallen back below the yields of equivalent US Treasury bonds.
Markets look ahead. All eyes are on the Chancellor’s statement due on 31st October. Gilt markets have been spurred on by hints that the Treasury might look at such measures as windfall taxes on energy companies and banks to help fill the missing gaps in the public sector finances. If economist forecasts are close to the Treasury’s internal thinking, the abolition of £32 billion of tax increases is about half the money needed to ensure that Jeremy Hunt can stand up and say the OBR confirms that the debt to GDP ratio will be on a downward path. So far, the markets are assuming that the Treasury and the Bank of England are ring-fenced, indeed even benefitting, from the political chaos seen in Westminster.
Amidst the stream of political news, there was some hard economic data. The UK CPI was a touch above market expectations, growing 10.1% a year, led by food prices surging almost 15%. However, most economists do not expect it to move much higher, especially with the energy price cap support appearing shortly. There was further evidence of the squeeze on consumer incomes and business profits leading to a rapidly slowing economy. For example, the Federation of Small Businesses’ confidence index fell to its lowest reading outside the Covid lockdowns, with clear signs of less hiring taking place. All in all, it would be a surprise if the Bank of England moved by 1% rather than 0.75% next month.
Indeed, 0.75% is the magic figure which many central banks are likely to raise interest rates by in coming weeks. Markets are looking for 0.75% from the Bank of Canada on October 26th, the ECB on 27th, the Fed on November 2nd, the Bank of England on the 3rd, and in New Zealand on the 23rd. This helps explain why bond yields rose in the US and German markets this week, contrary to the sharp fall seen in the UK.
The terminal Fed Funds interest rate continues to oscillate around 4.75-5.0%. The Federal Reserve is watching carefully to see which sectors of the US economy are responding to its monetary tightening. Housing certainly is; with mortgage rates approaching a 20 year high of 7%, confidence has plunged amongst the National Association of Housebuilders. Third quarter corporate earnings reports show that cash balances are dropping rapidly. Yet the Fed’s Beige Book survey only referenced slowing activity and slowing inflation across most business areas. Taking account of recent moves in oil prices, economists still expect US inflation to be 3-4% in 2023. Minneapolis Fed President Neel Kashkari warned that the central bank may need to push its benchmark policy rate above 4.75% if underlying inflation does not stop rising.
The ECB remains in tightening mode, especially after September’s CPI reading was confirmed at 9.9% year on year. As well as action on interest rates, Bundesbank President Joachim Nagel and Dutch central bank chief Klaas Knott both said the time for quantitative tightening (sales of its massive bond portfolio) is approaching. ”Once we have reached neutral territory with our policy rate, it makes sense to consider the roll off of asset purchases by limiting reinvestments”, said Knot. “I do believe that we should move gradually here” said Nagel “as monetary policy continues to normalise, we will also need to look into scaling back Eurosystem asset holdings”. All in all, another 1.25% on rates is likely in coming months to take the official rate towards a terminal level of at least 2.25%.
A week of good news for UK gilt investors needs to be put into context. More comparisons are being made between the UK and Italian economies, political systems and problems with decision making. The spread between benchmark UK and Italian bond yields has moved back to about 0.75%. Looking ahead, uncertainty over medium term policy making will encourage investors to continue to demand a risk premium for holding sterling assets such as gilts. That is bad news for taxpayers, but good news for holders of UK bonds.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.58 4.36 4.15
UK 3.50 3.93 3.91
Germany 2.09 2.27 2.40
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