Bonds are meant to be boring. Investors buy them because they provide a predictable income stream. Pension funds buy them to hedge against their riskier bets. Prices and yields are usually dull and predictable – yet that is precisely the point.
However in recent months, the gilt market – as UK government bonds are known – has been turned on its head. Prices have been swinging wildly, moving at speeds not seen in years.
Last autumn, when a small corner of the market threatened to blow up the pensions industry, everyone blamed Liz Truss. The former PM’s infamous “mini-Budget” was permanently consigned to history before the ink had dried, and for a time things appeared normal again.
Yet the calm that Jeremy Hunt brought has proved only temporary.
UK borrowing costs are now back to levels last seen during the Truss premiership. Yields on benchmark 10-year bonds climbed by almost a quarter of a percentage point last week to as high as 4.4025pc and not far from the 4.498pc high they hit after markets were spooked by last September’s fiscal statement.
Yields on two-year government bonds, which are more sensitive to movements in interest rates, saw similar lurch upwards.
For comparison investors were demanding a return of just 0.075pc for the same bond less than three years ago.
What has changed? The difference now is rampant inflation.
Then, Rishi Sunak was trying to entice diners to “Eat Out to Help Out” as the UK crawled out of lockdown. Prices were stagnating, and the economy was still reeling from the biggest slump since the Great Frost of 1709.
Today, inflation stands at 8.7pc, well above the rest of the G7 club of rich nations. Food prices are soaring at rates not seen since the 1970s and even Bank of England governor Andrew Bailey admits he has no idea when prices at the checkout will start falling.
Core inflation, which strips out volatile food and energy costs, is also proving more stubborn, as are pay rises in a still-tight jobs market.
“I think we are seeing a wage-price spiral and to break it we need firms to find it harder to put up prices and employees harder to push up wages,” warns Martin Weale, a former Bank rate-setter.
The expectation of higher interest rates leads investors to demand a higher rate of return on bonds. Higher Bank Rate leads to higher interest rates across the market after all and investors must be fairly compensated for lending to the government.
But just how much higher will interest rates have to go to keep a lid on price rises? Is the Bank of England credible enough to get the job done? And how much more of a bumpy ride is in store for financial markets and the economy?
The answer to those questions is crucial not just to investors but to Britain as a whole. Higher borrowing costs make it harder for Britain to pay its way and risk leaving us all poorer.
The situation has led many to wonder if we are all paying the price for policymakers’ failure to get a handle on inflation.
Gilt trip
Investors have fallen out of love with UK bonds this year. Hunt’s “dullness dividend” has not been enough to shake Britain’s so-called “moron premium”, a term applied in the markets after the mini-Budget.
Whereas in September the blame was laid at the feet of Truss and her chancellor Kwasi Kwarteng, now many are placing the dunce’s cap on the Old Lady of Threadneedle Street.
Imogen Bachra, head of UK rates strategy at NatWest, says the overseas buyers and pension funds that used to hoover up gilts are now questioning if the UK offers value for money.
After all, returns on bonds are usually fixed, which makes them a riskier bet when prices are rising.
“These natural buyers of gilts have been noticeably absent this year,” says Bachra. “We don’t expect them to return until they have more confidence that inflation is on a convincing downward trajectory. Investors want to have more certainty over the path of interest rates, or at least more certainty that we’re quite close to or at a peak in Bank Rate. And both of those things were pushed further into the future with last week’s inflation data.”
She believes borrowing costs will continue their march upwards. Bachra and her team already believed 10-year gilt yields would hit an above-consensus 4.3pc this year. Having smashed through that threshold, they now see yields reaching 4.6pc by the end of this year.
This is because the UK’s Debt Management Office, which serves as the Treasury’s treasury, has been tasked with selling almost £240bn of debt this year. Outside of the pandemic, this is the highest on record.
A glut of supply naturally depresses prices, with yields moving inversely to price.
Add to this the fact that the Bank of England, which was one of the biggest buyers of gilts over the past 15 years, has recently become a seller.
After spending hundreds of billions buying up government debt in the post-financial crisis era, it is now trying to get rid of it.
Even British buyers are staying away. Legal & General Investment Management (LGIM), which manages more than £1 trillion in assets, is shunning the UK for the US, particularly when it comes to long-term debt.
With traditional buyers shunning government debt, retail investors are stepping into the breach. The head of broker AJ Bell said this week that purchases have soared.
But this group does not have the financial firepower to match the investors who are stepping back.
“I wouldn’t be surprised in this environment to see an overshoot of that [4.6pc prediction],” Bachra says.
Mortgage crisis
Rising government borrowing costs are not just an abstract concept: they have real world implications.
Banks use gilt yields and expectations for future interest rates to price mortgages. As a result, economists expect prices to rise rapidly.
The jump in rate expectations and gilt yields this week has pushed up swap rates – a benchmark for lenders’ own borrowing costs – to their highest level since October.
If swap rates stay this high, the burden will be passed directly onto borrowers, says Andrew Wishart, senior property economist at Capital Economics.
The average five-year fixed rate mortgage for a buyer with a 25pc deposit was 4.2pc in April but “the move in market interest rates suggests it will rise back up to around 5pc”, says Wishart.
For a buyer taking out a typical £200,000 loan, a 0.8 percentage point increase in mortgage rates would cost an extra £1,600 per year in interest. Over the course of a five-year fix, that equates to an extra £8,000 in interest.
Lenders such as Nationwide have already started to increase their rates. Brokers are expecting widespread price increase to filter through almost immediately.
This jump in mortgage prices will kill off the greenshoots that had been emerging in the housing market, says Wishart.
Capital Economics expects house prices will fall by 12pc from peak to trough. They have fallen by 4pc already, meaning the majority of the damage is still to be done.
“It will just be a matter of time before we see this feed through across the spectrum. It looks like we are headed into a more volatile period again,” says David Hollingworth, of L&C mortgage brokers.
“We have already seen mortgage rates pushing up a bit. This will just accelerate that. The pace of change is already picking up.”
As the jitters spread, brokers are already drawing comparisons to the autumn market turmoil.
“There are similarities to the fall out following the mini-Budget last year,” says Nick Mendes, of mortgage brokers John Charcol.
Then, interest rate expectations, gilt yields and swap rates rose so fast that banks pulled mortgage deals en masse and then raised their prices at the fastest pace on record.
Lenders are starting to pull deals and raise prices, though so far on a much smaller scale.
This week, a couple of hundred mortgage deals have disappeared. In the autumn, it was thousands.
Homeowners should not expect to see mortgage rates fall below 3pc within the next three years, says Mendes.
The increase will be a blow for buyers. However, the most vulnerable group will be existing homeowners.
The average mortgage-holder with a typical £200,000 loan will have to pay an extra £2,000 a year in interest if the Bank rate rises to 5.5pc, according to Pantheon Macroeconomics.
This average includes the homeowners who are still protected by fixed rate deals. For those who are remortgaging, the jumps will be much more dramatic.
Mortgage holders will see their monthly payments jump to up to 30pc of their income from about 20pc over the past few decades, the chief executive of Barclays warned this week.
CS Venkatakrishnan, known as Venkat, said the sharp rise in interest rates would lead to a “huge income shock” by the end of next year.
Bailey has warned that only a third of the effect of interest rate rises have been felt in the housing market so far.
Although the number of properties going into repossession is still historically low, many homeowners who are struggling will never appear in these numbers. Often, families will sell up long before their lenders intervene and it is clear that many households are already struggling as they adjust to the burden of higher mortgage bills.
In the last year, inquiries from homeowners who are in mortgage arrears have jumped by 50pc, says Paran Singh, of TIC
Finance, which provides specialist funding for homeowners struggling with their payments.
“If interest rates increase further, I would expect to see at least a further 25pc surge from now to the end of the year,” he says.
Rate expectations
Just how bad will the pain get? It is an open question just how high will policymakers at the Bank of England will need to take interest rates in order to tame inflation. The Monetary Policy Committee (MPC) responsible for setting them has already lifted rates a dozen times from 0.1pc in December 2021 to 4.5pc today.
Investors now believe they will hit 5.5pc by the end of this year.
Yet just over a month ago, markets predicted that the tightening cycle would be over by now.
The lurch upwards has been driven by inflation continuing to deliver nasty surprises.
Month after month, it has been higher than both City economists and the Bank of England have forecast.
This failure has eroded the Bank’s credibility.
Officials expected double digit inflation to end in February. When it didn’t, policymakers remained steadfast in their conviction that price rises would cool rapidly.
When inflation stayed in double digits in March, economists started to get nervous. Stubbornly high inflation in April, even as the headline rate dropped to its lowest in a year, was the last straw.
The inflation surprise forced half the City to tear up their interest rate predictions, with most forecasters now predicting rates of 5pc or more.
“The inflation figures were bad,” says Willem Buiter, a founding MPC member. He believes the Bank has been playing catch-up for a while. “To address the inflation problem, policy rates in the UK will have to increase materially and speedily.”
Buiter believes policymakers should raise rates by half a percent at their next meeting in June. “I see Bank Rate peaking at no less than 6pc.”
Weale, who sat on the MPC between 2010 and 2016, suggests the Bank’s blind belief that inflation is “strongly influenced by businesses’ expectations” is naive at best. Attempting to talk down inflation by managing business expectations is a folly.
“[Former Bank governor] Mervyn King referred to this as the King Canute theory of inflation,” he says.
Part of the UK’s problem is that there is more collective bargaining here than in the US. Doctors, rail workers and teachers have all threatened more strike action if their pay demands are not met.
Raghuram Rajan, a former chief economist at the International Monetary Fund, says: “It may be that the combination of low real wage growth in recent years and greater unionisation in the UK makes workers understandably more frustrated with inflation than in the United States and more willing to press their demands.
“This in turn could make inflation more persistent, even under the same set of conditions.”
Weale is known for choosing his words carefully, so his decision to describe the current situation as a “wage-price spiral” deserves notice.
“My own view is that bringing inflation down will be slow while the labour market remains as tight as it is,” he adds.
Jeremy Hunt has suggested that tackling inflation is the most important priority for the Government, with the Chancellor signalling he is willing to tolerate a recession brought on by higher rates if it curbs price rises.
The economics professor is more sanguine about the risks facing the economy from higher interest rates.
“I do not think a recession is necessary to break the wage-price spiral,” he says. “We could, for example, find labour supply increases again if the people who have dropped out of the labour market re-enter.”
However, he admits: “It is perhaps the most likely way of bringing pay growth down. At a time when productivity growth is very weak, almost any reduction in demand can lead to a recession. I do not think the Bank of England can break the spiral simply by saying that it is committed to 2pc inflation.”
The higher interest rates go, the more painful it will be for the economy, says Buiter.
“Can inflation be brought down to its target level over a two-year horizon without a recession? Everything is possible, but not everything is likely,” he says. “I fear that painless or immaculate disinflation is unlikely to be on the menu for Britain.”
Buiter expects additional policy action from the Bank of England to “produce at least a mild recession in the UK, starting at the end of this year.”
While this is a grim prognosis, it is seen as a necessary evil.
Michael Saunders, who left the MPC last year, says: “We have to break [inflation] because the longer it persists, the more deeply it becomes entrenched, and the more costly it is to get back to the inflation target. There is a cost to waiting.”
This is the new reality that investors have been reacting to this week, sending the gilt market haywire.
Thankfully, pension funds are in a better position than they were last October. A jump in borrowing costs in the wake of the mini-Budget left many funds that used Liability Driven Investment (LDI) strategies struggling to meet huge cash calls, which sparked the autumn turmoil.
Funds have learned their lesson: many have built up their cash cushions, meaning they are better prepared in the event of more market chaos.
Bachra says: “Anecdotally, we hear that they’re almost double the size now than they were last year. So they’re better able to withstand those high yields. And even if we move to these high yield levels, compared to last year it’s been in relatively small increments. So I’m not concerned that this creates a repeat of last autumn.”
However, Rajan, now a professor at Chicago Booth University, warns the risk of another market meltdown remains significant.
“Until inflation is firmly under control, it is probably premature to say we have seen the last of volatility,” he says.
‘It’s going to be painful’
The Chancellor was quick to say a recession was a price worth paying to quash inflation.
“If we want to have prosperity, to grow the economy, to reduce the risk of recession, we have to support the Bank of England in the difficult decisions that they take,” he said.
The Bank’s actions have direct consequences for Hunt’s because he faces delivering his Autumn Statement against a darkening economic backdrop that could force him to raise the tax burden further.
Ruth Gregory at Capital Economics, who used to work at the Office for Budget Responsibility (OBR), says back-of-the-envelope calculations suggest each one percentage point increase in gilt yields would raise the Government’s debt servicing costs by £8.9bn by 2027-28.
Every one percentage point increase in short interest rates increases debt interest costs by £7.9bn.
Market movements this week “if sustained, might together be expected to add about £8bn-£9bn to the Government’s debt interest payments by 2027,” she says.
This would instantly wipe out the Chancellor’s already miniscule £6.5bn headroom to meet his fiscal rule to get debt falling after five years.
He will have another year to play with as the economic and fiscal forecast rolls forward another 12 months. Stronger short term growth may help to offset the impact of higher interest rates. Whether that comes to pass will be a crucial factor in whether the Chancellor is able to deliver pre-election tax cuts as he would like to.
Bachra says there is still time for markets to swing back in Hunt’s favour, and still believes politics will trump economics in the end.
“We’re heading into an election year. And so I think any headroom that the Government does have from a fiscal perspective will just be recycled into pre-election giveaways in the months [ahead of the vote].”
Ultimately though, giveaways will do little to mask the tough path ahead. So long as inflation remains above the Bank’s 2pc target, the country is destined to bear the brunt of higher rates.
Saunders, who is now a senior adviser at Oxford Economics, believes getting inflation back to 2pc will not be difficult, though it will come at a price.
“We can get there. But it’s going to be painful. Painful for the economy, painful for households, and painful for businesses.”
Source: finance.yahoo.com