This was first published on Netwealth – 26 October 2023
Bond yields continue to be the centre of market attention. As is often the case with large and long-drawn-out market moves there are a combination of factors at play. After being a safe haven during the pandemic, the last few years have seen a steady increase in bond yields, as inflation and policy rates have risen and supply worries have come to the fore.
The markets’ primary focus has been on the US where, as we have noted in recent weeks, there has been a greater debate on the increase in the term premium. This is the extra premium that is reflected in longer-term bond yields to compensate and encourage investors for the added uncertainty associated with holding longer-term debt relative to short-term debt. This uncertainty is seen as having risen in the US, largely due to greater concern about the future fiscal outlook, as the US is running a large budget deficit and has a proactive fiscal stance.
Interestingly, in the UK, there tends to be far less focus or debate about the term premium. But while we do not have the same fiscal stance as the US, the same other broader influences are impacting yields here. Namely: inflation may be falling but at 6.7% it is still way above its 2% target and there is persistence and uncertainty about where it will settle; policy rates of 5.25% are at or close to their peak but they are likely to settle at higher levels in the future than in the past; the market is still digesting the switch from the Bank of England being the main supporter of the gilt market to its role as being a net seller.
The most significant issue – for the economy as well as the gilt market – is the end of the cheap money policies that persisted for far too long in the UK and other western economies. Crucially there are two components to this that have major implications for bond yields: the normalisation of policy rates and the reversal in central bank balance sheet policy, away from boosting it via Quantitative Easing (QE), towards shrinking it through Quantitative Tightening (QT).
For the gilt market this means a seismic shift with the biggest buyer now being an ongoing seller.
Ten-year gilt yields are 4.56%. This century the high was 5.87% in January 2000. The average ten-year gilt yield this century has been just over 3%, with the first move into very low rates being in late December 2011, when they dipped below 2%, and they remained low for a lengthy spell.
At that time, as I then argued, the UK should have taken advantage of the situation and locked into borrowing at very low long-term yields to finance necessary infrastructure investment. It didn’t, and instead wrongly engaged in austerity. Ten-year yields then edged back up to 3% by the end of 2013 before, once again, continuing a long downward decline. The low was 0.08% in April 2020. Again, we should have locked into longer-term borrowing at that time.
As we noted recently, in the G7 the UK is second only to France in terms of the scale of government bonds that are bought by overseas investors. Given the scale of the debt that the UK must sell this potentially makes funding the deficit more vulnerable to any sudden change in global investor sentiment towards UK sovereign assets. Such a shift could be triggered by events in the UK or indeed by contagion from elsewhere.
This might limit the extent to which gilt yields could fall if the economy weakens. That is, even though the combination of lower inflation and weak growth over the next year, or two, would normally exert downward pressure on ten-year yields, the extent to which yields fall may be limited.
The combination of these factors is seen in the shape of the yield curve. It is currently inverted, with ten-year yields 0.27% below two years, but back in April it was even more inverted with ten-year yields then 0.91% below two years. It is the same in the US, where the yield curve is inverted, with the yield on US ten years 0.21% below two years, although in August this inversion was 1.08%.
An inverted yield curve is a sign the market is worried about the economy. Yet, while the US Federal Reserve and the Bank of England may be under pressure to ease in the second half of next year, the likelihood is that policy rates will have to settle at a higher level in future. The market is now discounting this. Alongside this, the replacement of QE with QT means a fundamental shift in the market.
In the US, the buying by the Fed of Treasuries was regarded as the dead hand. One could take this analogy further and say – whether it is the US or the UK – the visible hand of the central bank in supporting the bond market is being replaced by the invisible hand of the market. It was known what the central bank would do to support the market. It was visible. Now, there is greater uncertainty as markets are impacted by many factors.
In that context keeping the markets onside is critical. There are many facets of this for policy makers. While there must be consistency between monetary and fiscal policy that doesn’t mean they have to always do the same thing – a point not always appreciated by the market. It depends upon macro-economic conditions.
Trouble is, neither fiscal or monetary policy offer more room for policy manoeuvre, currently, and while economic supply-side policies might offer that, such as changes to planning to boost housing supply or measures to stimulate investment, policy changes there can take time to be agreed and executed. That will always add to the pressure for fiscal or monetary policy to be relaxed if growth is sluggish.
Next month is key
There certainly should be both credibility about the policy stance and clear communication of it. A real test of this will arise over the next month in the UK, with the next Bank of England policy meeting, alongside their quarterly Monetary Policy Report next week, and the Autumn Statement on November 22nd. (I will focus on the Autumn Statement in coming weeks, but even though recent borrowing numbers are better than official projections, the Chancellor has been keen to manage expectations of any stimulus ahead of the Statement.)
The UK economy has been resilient but is now better described as sluggish, for although it has been avoiding recession, recent purchasing managers’ surveys suggest the economy may be contracting. Also, the labour market which has been resilient is softening, consumer confidence appears fragile, and monetary indicators are weak, consistent with a tougher financial outlook.
The expectation has been that lower inflation will help spending power and while that is still the case, a risk is that oil prices may now be firmer than previously expected because of the geopolitical situation in the Middle East. That oil price influence alone has the potential – depending on how things evolve – to be stagflationary, in that it may limit the speed and scale at which inflation falls. But it will not stop inflation falling. This should suggest that bond yields should take solace from the economic outlook.
As we have stressed before, while headline inflation is decelerating and should bottom out next summer, core inflation may prove stubborn, and thus inflation may settle at a higher level in the future – say 3% – than previously. The Bank of England, though, will likely reiterate next week that it expects inflation to settle eventually at the 2% target.
This coming week’s policy meeting should confirm whether rates peak at their current 5.25% or at 5.5%. Monetary policy has moved from far too loose to now being probably too tight, given the lags involved in the impact of policy feeding through. Policy rates in the UK have risen swiftly from 0.1%.
While the market is not fully factoring in another rate hike it has not ruled out the possibility that one could occur. I think that’s right. I don’t think rates should rise further and I don’t think they will. They are already too high. But the Bank’s reading of the economy and their communication is poor and thus a further hike could yet happen. Despite all this, the markets are assuming a 0.25% cut in the base rate in the second half of next year. That, too, is likely, with the markets also discounting future easing by the Federal Reserve, too.
Crucially, whatever happens to policy rates over the next week, because of ongoing QT, there will still be monetary policy tightening, only this will impact more through the longer-end of the yield curve. A year ago, the Bank’s Monetary Policy Committee (MPC) voted to reduce the stock of gilts by £80 billion. As the Deputy Governor for markets David Ramsden noted in July, “By the end of September 2023, this will have reduced the size of the total APF (Asset Purchase Facility) by 11.6% when including corporate bond sales.”
A year ago, the Bank also committed to an annual review of its QT policy, and because of that has opted to since increase the scale of QT. As the minutes of its recent September 2023 MPC meeting noted it will, “reduce the stock of UK government bond purchases held for monetary policy purposes, and financed by the issuance of central bank reserves, by £100 billion over the period from October 2023 to September 2024, to a total of £658 billion.” This compares with a peak of £895 billion towards the end of 2021.
While the Bank is always keen to stress that it is the policy rate and not QT that is the “active tool for monetary policy” – which is correct – and thus that QT should be thought of as operating in the background, the reality is that nonetheless, its impact is significant. So even when policy rates have peaked, the shrinking of the Bank of England’s balance sheet means that monetary policy tightening will continue.