The focus in global fixed income markets continues to be on government yields and the question of whether they are telling us something about the future path of growth.
Over the last three months 10-year US treasury yields have fallen from 1.70% to a low of 1.13% last Wednesday. Over this period UK 30-year yields have fallen from 1.4% to below 1% and equivalent real yields have hit -2.4%, mirroring the 40bps decline in nominal yields. What that means is that if inflation hits the Bank of England’s (BoE’s) 2% target over the remaining life of the 2051 index linked gilt the capital payment received on maturity will be less than the current price. Yes, we may refer to government real yields as the ‘risk free rate’ but let’s appreciate that this inflation insurance comes at a big cost.
The conundrum is how to square nominal and real yields. The gap is a measure of future inflation and this is saying that inflation is picking up; nominal yields are saying that growth is going to be anaemic going forward. There is always the danger of over-interpreting market yields – they are an immediate point in time view. If you ask government managers whether government bonds are good value over the long term I expect the majority answer would be ‘no’. However, a fair few will say that is the wrong question: we should be asking ‘are yields going lower over the next three months?’ This may come down to the impact of Covid variants, technical supply of government bonds, LDI hedging and current market positioning.
Inflation remains key to the outlook for monetary policy. There are a range of opinions – both here and in other countries. In the UK The Times ‘shadow Monetary Policy Committee (MPC)’ sounded an alarm bell with all members of the view that quantitative easing (QE) should be stopped now – at £845bn – reflecting concern about inflation. The reality was different with the actual MPC voting 7-1 to continue with the programme. But at the same time the Bank of England expects CPI inflation to hit 4% later this year; the revision in estimate primarily reflects higher energy costs. The BoE remains confident that stable or reducing energy costs and lower goods price inflation will allow CPI to return to target by late 2023. What could go wrong? The biggest unknown is about inflation expectations. The BoE may be confident about future inflation but will the public? A lot of attention has been focused on goods price inflation but my concern remains the much larger segment of services. This is subject to less price competition in my opinion and with such a large part of the UK (and US) economy based on services, this is the area that may impact inflation expectations. If labour shortages work through into these areas the return to target will take more time.
Cash and government bonds
Government bonds ended on a weak note – after performing strongly in previous days. UK 10-year rates finished above 0.6% whilst US yields moved above 1.25%. In the UK breakeven inflation was higher across the curve. This was most noticeable at longer maturities where 20-year implied inflation moved above 3.6% (CPI / RPI). Euro government markets outperformed over the week with Italian and Spanish yields approaching February lows.
Sterling was a bit weaker against a relative strong US dollar.
In sterling credit there was a blow-out issue from Berkeley Group, the upmarket housebuilder. I have always been interested in this company from my earliest meetings with Tony Pidgely – the man who really drove Berkeley to be the force it is today. Along the way there have been some scary times – which made us a bit cautious on lending on an unsecured basis. Nevertheless, we did participate, although the final allocation was relatively low across our funds. At a spread of 1.95% over government yields the bonds tightened to below 1.8%, a pretty good indication of the demand for BBB debt.
In global markets events in China still dominated high yield sentiment. Credit spreads continue to drift with indices showing a marginal widening.
Watching the Lions lose on Saturday reminded me that sport is a good proxy of our working environment. If you don’t seize the moment your opponent / competitor will. Maximising your advantage when you have it has to be a core skill. Both the Lions and the England football team have recently demonstrated that failure to do this is costly. Let’s hope we don’t regret the BoE inertia on inflation.
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 the author’s own and do not constitute investment advice.