Last week was a great example of how a consensus evolves. An outlier view – for instance that UK rates will rise in Q4 2021 – gets airtime. Data then starts to provide evidence of stronger economic growth, the media focuses on rising energy prices, policy setters start sending mixed messages which get analysed to the last comma, and markets get jolted from their compliancy and overreact.
Suddenly, there is an inevitability: the minority become the majority. I am afraid I fell victim to this last week. I had thought that the Bank of England (BoE) would resist a move to increase rates but because the market was pricing in this outcome, I felt that the BoE would acquiesce. We know rates are going higher over the next few months – so why not go ahead, given that the market had given a green light? Instead, we got no rate rise; the line taken was that more data was needed about the labour market, that cost pressures were global and that households may need more time to adjust to the prospect of higher rates. Hats off to Melanie Baker, RLAM’s Senior Economist, who stood against this consensus and was saying no rate rise this year.
All this added up to a more volatile week in UK government bond markets. Two-year yields have been all over the place in the last few weeks: less than 20 bps in early September, approaching 75bps in mid-October and now heading towards 40 bps. At the ultra-long end, yields have not changed much when compared to early September, at around 90 bps. What this does not tell is that these rates were 50 bps higher in October. Or looked at in price terms: ultra-long gilts have returned nearly 20% from their low point less than four weeks ago.
Quantitative easing (QE) will now be completed by year end and it looks more likely than not that proceeds from the March 2022 gilt maturity will be available to maintain the stock of government bonds at £875bn (not available if the Bank Rate is at 0.5% or above at that time). This means that another £28bn will be used to buy gilts. So, even though the surprise last week was at the short end we saw long gilts getting another turbo charge.
Cash and government bonds
Last week the US Federal Reserve announced tapering, reducing bond purchases by $15bn a month and leaving them on track to cease purchases by the middle of 2022. Although Chair Powell said he thought they could be “patient” on rates, Melanie thinks he is preparing the ground for a potential rate rise next year. A lot of emphasis was placed on the labour market, but Powell acknowledged the problem of assessing employment conditions in a Covid impacted world. It is probably fair to say that transparency and communication skills have been more evident at the Federal Reserve than the Bank of England.
US treasury 10-year bond yields dipped below 1.5% and long-dated US real yields fell to -0.4% with implied inflation remaining elevated. In Germany 10-year yields fell sharply, moving towards -0.3%; this was reflected through the euro area although Italy and Spain have lagged the rally. One market that has seen big change in yields in recent weeks is Australia, where inflation data has overwhelmed the central bank’s desire to keep control of short rates.
Sterling fell against the US dollar following the Monetary Policy Commitee (MPC) decision to maintain Bank Rate. However, in big picture terms the impact on the currency was muted with sterling stronger against the US dollar and euro on a three-month view.
Last week was quiet in investment grade markets with spreads not much changed. A constant theme is that cheap money and the growth of private equity make underperforming companies vulnerable to takeover. I say underperforming – but that is not always the case.
Morrison’s was performing pretty well but its share price performance was pedestrian. Was that the fault of management or a failure by investors to appreciate the attributes of the business? In any case this means that as credit investors we need to protect our clients from adverse outcomes, where existing debt is subordinated within highly leveraged structures. We do this by looking to get close to the assets of the issuers, preferring operating to holding company debt and seeking strong covenant protections. This has worked pretty well for us – and I think will continue to.
However, sometimes takeovers work in favour of credit investors: either where existing debt has to be bought back or where a weak issuer is bought by a stronger company. Last week saw a possible case of the latter with Metro Bank’s debt rallying on Carlyle Group’s takeover interest. While we don’t have much exposure in our funds it will be interesting to see whether this sparks more consolidation in the ‘challenger’ bank sector – an area which has generally failed to live up to its billing.
On the high yield front spreads were wider, with adverse sentiment in emerging markets leaking wider. Spreads in sterling and euro markets were under a bit of pressure as supply weighed – although the US dollar market remained well supported.
I have written about trust in previous weeks – and its importance in the way people and therefore markets work. It is not easy being a central banker in today’s uncertain times and the BoE’s job has just got a bit harder. Market participants will be more wary of communications from MPC members and subtle shifts in BoE emphasis may not have the desired impact. Overall, I think they came to the right conclusion but caused collateral damage in getting there.
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