This week’s blog is written by portfolio manager CJ Cowan
The march higher in gilt yields during August has caught the eye of several members of the press, sparking comments that 30-year gilt yields are back to levels last seen in the late 1990s and that the UK is heading for an International Monetary Fund bailout. Given the hysteria, it seems like a good time to delve into what’s been driving the gilt sell-off and whether the doom-mongering is justified.
Commentary on the bond market had a similar tone at the beginning of the year. 30-year gilt yields rose by almost 0.4% in December, and this continued into the first weeks of January. It was popular to blame the chancellor and her October budget, with critics suggesting this was a repeat of the Truss mini-budget drama in 2022.
In fact, almost all the move in gilt yields could be explained by what was happening in the US. Treasuries were selling off and longer maturity bonds underperformed as the yield curve steepened, indicating investors’ reticence to lend to the US government for longer terms due to expectations of ongoing fiscal largesse.
While the UK no doubt had (and still has) significant fiscal problems of its own, moves in the gilt market weren’t notably worse than in the US or Europe, so it wasn’t right to blame the sell-off on a budget announcement that happened a month or two earlier.
Since the start of August, US Treasuries have delivered positive returns in aggregate, while the UK gilt market has done the opposite. This means we can’t credibly blame the recent UK sell-off on the US. For anyone with a tendency to bash the UK, it is tempting to suggest once more that the market is now punishing our unsustainable fiscal trajectory - but is that really what’s happening?
If the recent sell-off was specifically about the UK’s debt sustainability, then underperformance compared to the US would mainly happen in long maturity bonds. This is because if the credit quality of a bond issuer is on a worsening trend, investors should be more concerned the longer they are lending for and should demand compensation for this additional risk in the form of higher yields.
However, shorter-dated bonds in the UK have been performing the worst on a relative basis, with the yield on two-year gilts increasing while the yield on two-year Treasuries has fallen. This reflects differing paths of monetary policy rather than debt sustainability concerns. In the US, the labour market is weakening, inflation is relatively well behaved (albeit tariff-driven increases are likely), and Trump is attacking the independence of the Federal Reserve. All this contributes to investors’ expectations for several interest rate cuts over the next year or so. In the UK, the labour market is softening too, but inflation is moving higher, limiting the extent of interest rate cuts that the Bank of England can deliver to support growth.
Of course, fewer rate cuts mean that when we come to roll over our debt, we will be paying more interest, further worsening the budget deficit and debt-to-GDP ratio. In this way, monetary policy is inescapably linked to fiscal sustainability.
Meanwhile, there are other reasons to be nervous about long maturity gilts as well. Defined benefit pension funds have historically been big buyers of these bonds, but as schemes are bought out by insurers or converted to defined contribution, demand for long-dated gilts is falling, putting upward pressure on yields.
The UK is no doubt in a bit of a mess, and it is not easy to discern what a politically feasible route out of our current high spending, high tax and low growth malaise might be. However, if we want to pin the blame for the recent gilt sell-off on anything, the yield curve is telling us that the main culprit is really the UK’s nagging inflation problem and the elevated path of short-term rates that is expected compared to elsewhere.
CJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPHil in Economic and Social History from Brasenose College, University of Oxford.
What’s the big picture?
As the summer holidays draw to a close, Ian Jensen-Humphreys takes a step back from the day-to-day noise to assess the current economic and investing landscape from a broader perspective.
