Gilt corner: shouts of ‘may’day from the Bank


Craig Inches, Head of Short Rates and Cash

23 October 2017

Poor Theresa May. Despite her raft of jobs as de facto Prime Minister, EU conciliator and chief political cartoon subject extraordinaire, she was demoted to the UK’s second most important ‘may’ this week. That honour goes to the ‘may’ uttered by Mark Carney in his Treasury Select Committee appearance, when quizzed on the possibility of interest rate hikes in the near future.
 
This single syllable was enough to release a flood of doves from their coops, with major Bank of England players including Haldane and Cunliffe all reverting back to a more cautious stance on the path and pace of any future interest rate hikes. Grammar fanatics amongst the bond community also pointed to Carney’s use of the word hike, as opposed to the plural and gilts reacted accordingly on Tuesday, rallying in response.
 
The Bank of England had been veering close to behaviour usually displayed by the US Federal Reserve, lining up market expectations (and consequently asset prices) for an interest rate hike in advance, a process which usually occurs in a fairly orderly manner. The actions of policy makers in recent days are distancing them from this model, but risk damaging their credibility should they fail to deliver.
 
While raising the base rate back to 0.5% is simply a return to the ‘normal’ policy conditions of the past few years, nevertheless the bank’s reversal towards caution has backed them into a corner. The recent relative strength in sterling and consequent suggestions that inflation hit a peak in September are both based partly on the assumption of a base rate of 0.5% being set at the November meeting. And while real wages are falling, the 6 month average of annualised earnings is actually fairly strong by recent standards. 
 
Anything but a hike could deliver markets an unwelcome post-Halloween scare. But given the asymmetry of this upcoming vote, in our government bond funds we’ve been reducing a lot of the short positioning at the front end of our funds. We’ve also been starting to build up our linker positioning in conventional gilt funds, where we’d been previously underweight.
 
Further afield, this week government bonds will dance to the tune of central bankers across the channel in Europe, where details of a major tapering in quantitative easing are on the cards at this week’s European Central Bank meeting. Current chatter suggests a halving of monthly asset purchases, but with these purchases continuing over a longer period, with more flexibility to extend this if appropriate. 
 
In a world where the Portuguese government can now borrow more cheaply over 10 years than the government of the United States, easy monetary conditions and low rates in Europe look set to rule the roost for some time to come.
 
 
Source, Bloomberg as at 20 October 2017. Chart shows the spread available on 10 year Portuguese government debt above 10 year US Treasuries.

Poor Theresa May. Despite her raft of jobs as de facto Prime Minister, EU conciliator and chief political cartoon subject extraordinaire, she was demoted to the UK’s second most important ‘may’ this week. That honour goes to the ‘may’ uttered by Mark Carney in his Treasury Select Committee appearance, when quizzed on the possibility of interest rate hikes in the near future. 

This single syllable was enough to release a flood of doves from their coops, with major Bank of England players including Haldane and Cunliffe all reverting back to a more cautious stance on the path and pace of any future interest rate hikes. Grammar fanatics amongst the bond community also pointed to Carney’s use of the word hike, as opposed to the plural and gilts reacted accordingly on Tuesday, rallying in response. 

The Bank of England had been veering close to behaviour usually displayed by the US Federal Reserve, lining up market expectations (and consequently asset prices) for an interest rate hike in advance, a process which usually occurs in a fairly orderly manner. The actions of policy makers in recent days are distancing them from this model, but risk damaging their credibility should they fail to deliver. 

While raising the base rate back to 0.5% is simply a return to the ‘normal’ policy conditions of the past few years, nevertheless the bank’s reversal towards caution has backed them into a corner. The recent relative strength in sterling and consequent suggestions that inflation hit a peak in September are both based partly on the assumption of a base rate of 0.5% being set at the November meeting. And while real wages are falling, the 6 month average of annualised earnings is actually fairly strong by recent standards.  

Anything but a hike could deliver markets an unwelcome post-Halloween scare. But given the asymmetry of this upcoming vote, in our government bond funds we’ve been reducing a lot of the short positioning at the front end of our funds. We’ve also been starting to build up our linker positioning in conventional gilt funds, where we’d been previously underweight. 

Further afield, this week government bonds will dance to the tune of central bankers across the channel in Europe, where details of a major tapering in quantitative easing are on the cards at this week’s European Central Bank meeting. Current chatter suggests a halving of monthly asset purchases, but with these purchases continuing over a longer period, with more flexibility to extend this if appropriate.  

In a world where the Portuguese government can now borrow more cheaply over 10 years than the government of the United States, easy monetary conditions and low rates in Europe look set to rule the roost for some time to come. 

 

Source, Bloomberg as at 20 October 2017. Chart shows the spread available on 10 year Portuguese government debt above 10 year US Treasuries.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.