Pulled this way and that!
UK gilt yields are primarily driven by developments in the UK economy, and hence Bank of England policy decisions, but no bond market exists in a vacuum. Gilt investors must also pay close attention to developments, and hence buying or selling opportunities in other major markets, especially Europe and the USA where they can invest easily. To that extent, UK gilt yields are partly being pulled higher by ECB decisions but lower by Federal Reserve actions.
In the USA, Fed speakers all but confirmed that interest rates will rise by 0.25% in February. Lael Brainard, John Williams, and Christopher Waller gave similar views. For example, Vice Chair Brainard said the chances of a “soft landing” appear to be growing, whilst monetary policy is “now in restrictive territory, and we’re probing for the sufficiently restrictive level”. Market moving economic data has recently been limited. Leading indicators remain weak, and there is a declining trend in total job openings, albeit measures of financial conditions continue to ease and there was a degree of stability in some business activity indicators in January.
The canary in the coal mine might be ‘the debt ceiling’. Every few years, journalists dust off articles about death and destruction facing the global financial system from the US government hitting its self-imposed ceiling to limit debt issuance to $31 trillion. In theory an inability to issue new government bonds could mean the temporary shutdown of Federal government, or a downgrading of Treasury debt, or a collapse in the US dollar. Treasury Secretary Janet Yellen has warned that the crunch date will be in early June, depending on a range of extraordinary measures to limit day-to-day spending and draw down cash balances. Eventually, the debt ceiling will be formally raised, but the usually tortuous negotiations are complicated by the knots which Kevin McCarthy has tied himself into as the cost of becoming Speaker of the House of Representatives. All in all, investors should not be surprised by volatility in shorter dated Treasury yields.
In contrast to the Fed’s stance, a series of ECB speakers such Nagel, Makhlouf and Vasle made it clear that 0.5% rate moves are likely in February and March, with the proviso of course that policymakers must “wait and see exactly what the data tells us”. ECB President Christine Lagarde said rates will have to “rise significantly at a steady pace” and “we will stay the course to ensure the timely return of inflation to our target”. News that the latest business surveys indicated a small improvement in activity levels into January, whilst French and Italian companies indicated that an economic slowdown may only be short-lived, will have confirmed the wisdom of such views. Hence the terminal rate expected by the marketplace is still between 3.0-3.5%.
The UK is caught between these two views. Surveys of retail spending look weak, whilst measures of consumer confidence are very soft. Manufacturing and service sector surveys both show contraction, and the CBI industrial orders index deteriorated further this month. However, the Bank will also be watchful of the government’s debt servicing costs. Net borrowing by the Treasury stood at £27 billion in December, the highest figure for December borrowing on record and nearly double the amount borrowed a year earlier. Government debt has continued to surge after the decision in October to subsidize energy bills whilst higher borrowing costs translate into much higher debt interest payments – £17 billion last month, another record-breaking number. Future borrowing will be affected by Office for Budget Responsibility forecasts, with reports that the OBR will reduce its 2023 growth estimates by between 0.2% and 0.5%, largely due to labour shortages. All this has contributed to the view that whilst the Bank will take interest rates towards 4.5% by the summer there is growing speculation there will be a rate cut by year end.
The ebb and flow of the marketplace is seen in bond yields generally moving a little higher last week after dipping the week before. Whether the ECB or the Fed are correct in their policy outlook, or new surprises affect all bond markets, will help determine which way gilt yields go into the spring.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.20 3.62 3.53
UK 3.44 3.18 3.31
Germany 2.59 2.23 2.21
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