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Our views 01 November 2021

JP’s Journal: Disarray in the gilts market

5 min read

In the UK, the Budget was at the forefront of domestic financial news last week. The Chancellor had one card up his sleeve: the Office for Budget Responsibility (OBR) now sees less economic ‘scarring’ from the pandemic than previously expected.

What does this mean? Well, growth next year is expected to be stronger, resulting in an effective fiscal ‘windfall’. In plain terms, tax receipts next year will be better than forecasts, due to better growth and tax hikes. This has given scope for more spending and more ‘savings’.

It was the savings element that drove big moves in the UK government debt market. The Debt Management Office (DMO) has a remit to fully finance the UK government’s projected requirements each year through the sale of debt. As there has been a surprise improvement in the projected fiscal position, despite higher spending pledges, there will be fewer gilts issued next year. This does not sound like a big deal – but it is. It means that gilt sales will be about £60bn lower than thought, resulting in the cancellation of 14 auctions. Put another way – issuance will be about 25% lower than previously forecast.

The DMO is obligated to fully finance under its mandate. But is this sensible at all times? This approach has the benefit of transparency and keeping a distinction between monetary policy and debt management. But it has caused real problems in the gilt market; at times on Wednesday (27th October) the gilt market was in disarray. The longest dated gilt saw its price move from 118 basis points (bps) last Monday to a high of 134bps on Wednesday. Ultra-long dated real yields pushed further into negative territory, moving below -2.4%.

Let’s look at why this has happened. Lower supply was the main cause, but ongoing quantitative easing (QE) is another, as the Bank of England (BoE) still has £20bn of gilts to buy before year-end. If we take a step back and ask what the BoE is trying to achieve, it is not obvious. Markets are awash with liquidity, risk assets are buoyant, long-term interest rates are eye-wateringly low and the UK economy is set to grow by more than 5% next year. These are not the conditions that merit the immediate completion of QE.

The lack of flexibility given to the DMO and being shown by the BoE risks a nasty hangover later next year. A squeeze on disposable income may crimp tax receipts more than expected at a time when the QE support is stripped away. We won’t be talking about a shortage of long gilts in 2023. The step up in government spending seen over the last few years will not be easily reversed given our demographic profile and the government’s inclinations. We need to get used to bigger State spending and higher taxes; taxes are not coming down any time soon.

Cash and government bonds

Government markets continued to be volatile – with yield curve flattening being the dominant theme. Cash and short rates stepped higher; in the UK two-year gilt yields have moved from sub 0.1% at the end of July, to 0.7% at the end of October. Investors are pricing in four rate hikes over the next 12 months, taking the interest rate to 1%. It was only earlier this year we were prepped for negative rates.

UK 10-year yields moved significantly lower – to just above 1% – while US and German 10-year yields ended at 1.6% and -0.1% respectively. In the UK, the gilt yield curve implies marginal increases in interest rates over the next 20 years before a reversal kicks in. Beyond 40 years, implied rates are at or below 1%.

UK implied breakeven inflation fell sharply over the week – real yields fell a bit but nowhere near as much as nominal rates. Elsewhere, real yields did not change much, and breakeven (implied) inflation rates were generally lower.

Moves at the short end of markets have impacted our ultra-short-dated strategies and the flattening of yield curves was unhelpful for our government bond fund range. Risk looks well controlled, however, and we stick to our view that long dated yields are too low. 

Credit

Credit was a bit of a backwater last week. Investment grade markets chugged along, and prices reflected volatility in government markets rather than changes in credit spreads. On a relative basis this suits our approach: higher carry (portfolios yield more than benchmarks), well diversified, emphasis on security in our sterling strategies, and not a lot of duration risk against the benchmark. Bank results were generally encouraging, and this sector is seen as a beneficiary of higher short rates; we remain overweight in subordinated financial bonds (insurance and banks).

In high yield, spreads were a touch wider, but indices rallied on the move in government yields. There was an interesting new sustainability-linked bond from Teva, the Israeli pharmaceutical company. We passed on the deal as we felt that the offer yield did not compensate for risk – including potential opioid costs.

Performance across sterling and global credit strategies remains strong, driven by sector and security selection. As with the cash and government ranges, short-dated strategies have been impacted but relative performance against our peer group and benchmark remains good.    

The pandemic has shown the merits of a flexible mindset. Sticking to plans aids understanding but can lead to some potentially strange outcomes: higher short interest rates and ongoing QE, for example. Transparency is great – but keeping something up your sleeve for bad times is better.

 

Past performance is not a reliable indicator of future results. 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. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.