It’s a knockout – why the gilt and currency markets have no love for Carney’s forward guidance

Millwall FC wasn’t the only team to trek up to Nottingham yesterday from London and to come back empty handed (at the hands of the mighty, mighty Forest).  Team Carney from the Bank of England also had an unproductive time of it in the East Midlands as the new Governor gave his first speech in the role to the CBI, Chamber of Commerce and the Institute of Directors.  Since the publication of the August Inflation Report, in which the Monetary Policy Committee delivered its framework for forward guidance, the markets have done the opposite of what the Bank had hoped for.  The gilt market has sold off – not just at medium and long maturities, which are largely outside of direct Bank control and are more dependent on global bond market trends, but also at the short end, where 5-year gilt yields have risen by 20 bps in under a month.  There has also been a de facto tightening of UK monetary conditions through the currency.  Trade weighted sterling is 1% higher than it was before forward guidance came in.  Both the gilt market and the pound went the “wrong” way as Carney discussed forward guidance yesterday afternoon.  The Overnight Index Swaps market (OIS), which prices expectations of future official rate moves, fully prices a 25 bps Bank rate hike between 2 and 3 years’ time.


So why don’t markets believe Mark Carney?  In yesterday’s speech he was clear that the UK’s economic recovery was “fledgling”, and weaker than recoveries elsewhere in the world.  He spent some time discussing how a fall in unemployment to the 7% threshold would mean 750,000 new jobs having to be created, which would take some time, possibly three years or longer.  And even if growth picked up, it didn’t necessarily follow that jobs growth would be strong.  But two things led gilts lower yesterday afternoon.  Firstly there was the announcement that UK banks would be able to reduce the amount of government bonds that they hold as a liquidity buffer so long as their capital base is over 7% risk-weighted assets – potentially triggering sales of tens of billions of gilts over the next couple of years.  But more importantly, Carney’s attempted rollback from the “knockouts” stated in the Inflation Report was not strong enough.

On page 7 of the Inflation Report, after detailing the forward guidance linking rates and asset purchases to the 7% unemployment rate, there are three “knockouts” which would cause the guidance to “cease to hold”.  The first knockout is the most important.  If CPI inflation is, in the Bank’s view, likely to be 2.5% or higher in 1 1/2 to 2 years’ time then the unemployment trigger becomes irrelevant.  The other two knockouts were that medium term inflation expectations become unanchored, and that the Financial Policy Committee judges that the monetary policy stance is a significant threat to financial stability.

So for all the talk of the UK’s weak economy, and the accommodative stance that the Bank will take to allow the unemployment rate to fall to 7%, perhaps over many years, don’t forget that if CPI inflation looks likely to be at 2.5% or higher, the MPC will ignore the jobs market promise.  Since the middle of 2005, UK CPI has been at or above 2.5% most of the time, through a strong economy and (for longer) the weak economy.  Since the start of 2010 there have only been 3 months of sub 2.5% year-on-year CPI.  And in 2008 and 2011 the year-on-year rates exceeded 5%.


Of course, the Bank of England can forecast inflation to be whatever it likes over the next 1 1/2 to 2 years.  Its inflation forecasts have famously been awful for years, always predicting inflation would return to 2% when it always was much higher than that.  But it will be important for Carney to earn some credibility here in the UK, and the days of the Inflation Report’s “delta of blood” inflation forecast always showing a mid point for future inflation of 2% must surely have ended when Mervyn King left.  What does the outside world think about the prospects of UK inflation being below 2.5% in the future?  Here the news is better – the consensus broker economic forecast is for CPI to fall to 2.4% in 2014 and 2.1% in 2015.  And the implied inflation rate from the UK index-linked gilt market is for an average of 2.8% per year over the next five years on an RPI basis, which given the structural wedge between RPI and CPI suggests that the market’s CPI forecast is somewhere below 2.5%.  M&G has launched a new Inflation Expectations Survey, together with YouGov.  We should have August results shortly, but in our last release we saw that 1 year ahead UK consumer expectations of inflation ran at 2.7% (a fall from 3% a quarter earlier) and 5 year ahead expectations were at 3%.  Higher than the 2.5% target, but consumer expectations are often higher than the market, and the 3% level has been stable (well “anchored”).

But as we have seen, UK inflation has been notoriously sticky.  Not because consumers are demanding more goods than the shops can supply (although there has been some long awaited good news from the retail sector lately, with sales stronger), as in general real incomes have been squeezed and discretionary spending has been hit.  But because non-discretionary items, like food and energy costs, have substantially exceeded the inflation rates of consumer goods.  Add to this administered prices relating to public transport costs or university tuition fees and we can see that the UK’s “inflation problem” is potentially something that a monetary policymaker can only influence by forcing discretionary spending into deflation.  The chart below shows that so long as the non-discretionary basket of goods keeps inflating at around 5% per year, there must be virtually no inflation in discretionary goods in order to get below Carney’s 2.5% knockout.


So it is going to be tough for the market to believe that the CPI inflation “knockout” won’t have a decent chance of coming into play well before the 7% unemployment threshold is reached.  I think Carney missed an opportunity to move away from the knockouts yesterday – he certainly didn’t use the term again, and implied that the gilt market’s move lower was driven by international developments and over-optimism about the prospects for a quick fall in UK unemployment.  But the three knockouts were almost dismissed in the sentence “provided there are no material threats to either price or financial stability” rather than given the prominence that they were in the Inflation Report.  But it looks as if the gilt and currency markets need something stronger if they are to produce the monetary easing that, from Carney’s bearish analysis of the UK economy, it still needs.


Old Lady sells her bonds

Back in 2009 the Bank of England (the Old Lady of Threadneedle Street) began buying a portfolio of investment grade bonds to provide funding to UK corporates, to aid liquidity in the corporate bond market and to supplement their QE purchases of gilts. Last Friday this investor sold its last corporate bonds.

This has been a great success from a profit point of view. The attached chart shows the total return of an index of non-financial corporate bonds over the period of the bank’s purchases and sales as well as an indication of their total holdings.

I believe its actions helped stabilise the corporate bond market in the UK by providing a backstop bid, therefore helping to reduce the cost of funding at the margin for issuers, and would have added to the effects of QE. However, empirically measuring these effects is hard to do – corporate bond markets that experienced no domestic support from their central banks appear to have performed similarly, and the debate on the true effectiveness of QE remains.

What is the primary lesson we have learned? I think it is that state intervention can work where markets are priced inefficiently. This is illustrated by the large profits the bank has made by buying an out of favour asset class from the private sector. It is probably a good base to have the state intervene where markets are inefficient, for example in areas such as healthcare, defence, law and order, and infrastructure. The danger comes when the state interferes to the detriment of an efficient market. From an economic point of view, aggressive trade barriers are the first thing that comes to mind where there would be a great deal of consensus from the left and right side of politics. Other actions may depend on your economic or political view. The best current example of this is the single European currency experiment. Does it aid a free market via price transparency and low transaction costs, or does it hinder efficiency by having one single interest rate and exchange rate for such diverse economies ?

The Old Lady’s portfolio of corporates has served her and the UK well because she bought them at cheap levels from distressed sellers. Unfortunately, this investor has a significantly bigger portfolio of gilts. The carry and mark to market on these looks great. However, turning this unrealised gain into a realised profit still remains a challenge. If she comes to sell, her position is likely to drive the market against her.

old lady blog chart


Another year over – 2012 returns in fixed income markets

It’s been another massive year for the global economy. Europe saw LTROs, Greece got a haircut, sovereign downgrades and record high unemployment rates. The peripheral European nations attempted to implement austerity measures with limited success. The US re-elected President Obama and the focus quickly shifted to the upcoming fiscal cliff. In the UK, an Olympics induced bounce in growth was the sole bright spark for an economy which appears to be stuck in quick sand and may well lose its prized AAA rating in 2013.

The IMF, being unusually succinct, probably summed up the state of the global economy the best by entitling their latest World Economic Outlook “Coping with High Debt and Sluggish Growth”. The advanced economies account for around two-thirds of global GDP and if they are sluggish then global growth will be sluggish too.

With all this uncertainty and risk in 2012, how have fixed income markets performed? Surely government bonds will be the safe haven of choice?

In absolute and local currency terms, it’s been another great year for the markets with everything generating a positive return except UK linkers. It’s been a fall in grace for UK linkers, which were actually one of the best returning asset classes of 2011. The UK linker market was buffeted in 2012 by weak growth expectations and uncertainty surrounding proposed changes to the RPI calculation.

But looking elsewhere, investors had the opportunity to secure some excellent returns in 2012 by taking some risk. The best performing asset class of our sample was European subordinated financial debt which registered a return of 29.5%. European high yield wasn’t far behind with a return of 27.1%, followed by Sterling banks which returned 23.0%.

ECB President Mario Draghi and the ECB’s measures to support the Eurozone also had a positive effect of debt investors in peripheral Eurozone debt, with an index made up of bonds from Greece, Ireland, Italy, Portugal and Spain government bonds up 18.7%. Not a bad return for investors considering the question marks hanging over the ability of these nations to service their respective debt obligations in an environment of political uncertainty and recessionary levels of growth.

Other highlights include global high yield (up 18.7%), European peripheral financials (up 17.0%) and US high yield (up 15.6%). At the less risky end of the spectrum, European investment grade corporates returned 12.8% and US investment grade corporates returned 10.2%. Emerging market debt also did well, with EM sovereigns debt posting a fantastic return of 21.4%.

The dash for trash – YTD total returns in fixed income

As outlined earlier, it appears that the global economy faces some substantial fundamental headwinds. So how was it that the riskiest asset classes in fixed income have performed the best? Three little words – “whatever it takes”. Mario Draghi’s speech in late July supercharged returns for the riskiest asset classes and stimulated the “dash for trash”. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Well Mr Draghi, the markets have certainly believed you. For example, an index of government debt issued by Greece, Ireland, Italy, Spain and Portugal had up until the speech date generated a return of around 5%. The index ended up generating a 17% return, with investors comforted by Mr Draghi’s comments.

Super Mario to the rescue

It seems to us that the Ostrich effect (the avoidance of apparently risky financial situations by pretending they do not exist) had a significant impact on markets in 2012. And in a world of ultra-low interest rates and negative real returns in cash, investors must take on risk. It is precisely what central banks are encouraging us to do. But uncertainty breeds volatility and in order to generate higher returns investors must face this volatility head on. It will be a feature of the market in 2013.

About the only thing we can say for certain is that it is unlikely that fixed income will continue to generate excellent returns across the spectrum from government bonds to high yield. For example, double-digit returns in European investment grade are not normal and has occurred only three times in the last seventeen years. On the other hand, the asset class has posted a negative return in only two of those seventeen years, with the largest loss being -3.3% in 2008. In US high yield, the consensus amongst analysts is that high yield markets will generate a return of around 4-6%, the result of coupon clipping. Analysing returns for the asset class shows that a coupon-clipping year has occurred only once in the past twenty-five years.

We posted our bond market outlook last week. It looks like the US may experience a housing induced growth spurt, Europe will eventually get round to dealing with its issues and the UK has a long way to go to secure economic growth. We like non-financial corporates, are worried about EM debt valuations and remain confident that there are still attractive investment opportunities in several areas of the fixed income universe. For an expansion of these views and more, please see here.


Jim’s outlook for 2013. Eurozone volatility, poor emerging market debt valuations and a sterling collapse. Merry Christmas!

It may not have felt like it, but 2012 has actually been a pretty good year for investors. Bond holders in particular have had a decent 12 months: the government bond bull run has continued and investment grade and high yield corporate debt appears on track to deliver some excellent returns. Major equity markets also look likely to end the year in the black.

These broad-based gains on global stock and bond markets have occurred against a still challenging macroeconomic backdrop. In fact, looking back at our last annual outlook, many of the things we were worried about then – “double dips” and rising indebtedness in developed countries and the risk of a significant policy error worldwide – have not only remained unresolved but have become, in some cases, more of a concern. But it’s not all bad news and we’re pleased to note pockets of progress in some parts of the world.

So what does 2013 have in store for financial markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And remember, there are still a couple of days left to enter the M&G Bond Vigilantes Christmas quiz for 2012.



UK gilts – “Whoah we’re half way there, Whoah livin’ on a prayer…”

Last week the Bank of England announced a further round of quantitative easing of £50bn, bringing the total to £375bn. It is obvious that the MPC thinks that monetary policy is still not sufficiently loose to create the desired economic effect and hence further stimulus is needed.

We have written numerous times on QE. When we started scribing on this novel experiment we focused on why it needed to be done, and how it was meant to work (like walking on custard) and the bizarre effect this may have on the bond market.

One thing we did not focus on was the length of time monetary policy would have to be kept super accommodative, though we did expect it to be for an extended period of time (certainly until we begin to see a meaningful recovery in employment outcomes as outlined here).

Mervyn King appears surprised by the extent of the crisis. The MPC were slow in aggressively cutting rates after the onset of the credit crunch in 2007, but to his credit Mervyn and the UK authorities have been at the forefront of corrective action and have correctly realised the severity of the credit crisis. The MPC was correct to not interpret the inflation scare of 2008 or the economic rebound of 2009 as economic recovery. They have been spot on.

But how accurate is his current thinking?

The Governor is not one to pre-commit. However he did say something recently that shows how he feels about the potential long term outlook for rates. At the latest Treasury Select Committee he repeated that at this point in time – and he has said it at every committee meeting – that he believes we are not yet half way through the crisis.

“When this crisis began in 2007-2008, most people including ourselves did not believe that we would still be right in the thick of it, in the middle of it, quite this late. All the way through, I’ve said to this committee that I don’t think we are yet half-way through – I’ve always said that and I’m still saying it.” Mervyn King, June 26, 2012.

From the chart below we can see that BoE base rate has been set at 0.5% since March 2009, and over £325bn has been pumped into the financial system through QE. If we are not yet half-way through this crisis, then this implies that rates will stay at these levels for at least another 3 years to 2015, and a further round of £375bn of QE is potentially on the agenda.

If this interpretation of the outlook turns out to be correct then these very low levels of short and long term gilt yields begin to look more logical to gilt investors. And we can assume that the UK won’t recover fully until the US and Europe does as well, which means that ultra low yields on Treasuries and Bunds may also make sense.

Monetary policy is living on the edge, and if Mervyn King were to do a turn at a city karaoke machine, then the bar could well be ringing out to this Bon Jovi classic…

“Whoah we’re half way there, Whoah livin’ on a prayer…”

Naturally, his audience of gilt investors – despite the ultra low yield they are currently receiving – will sing back “We got to hold on to what we’ve got”.


Office of National Statistics or Office of National Savings? The Future of the UK’s RPI-CPI wedge

There has at almost all times been a ‘wedge’ between RPI and CPI, given different calculation methodologies (arithmetic mean vs geometric mean, respectively), different items within each, and different weights of these different items. The long term difference has on average seen RPI at 0.5% to 0.8% more than CPI. Recent changes, though, saw the wedge widen in 2007 to more than 2%, and to almost 2% again in early 2010.

Differential between RPI and CPI

What are these changes? RPI is a much older index, originally conceived in the early 20th century to track the effect of price moves on workers during The Great War, using less up to date and less relevant averaging calculations and, arguably in some cases, weightings and items. CPI was not developed until much later, in 1996.

Since the coalition’s formation we know that the government has been attempting to change certain future liabilities’ (eg public sector pensions and benefits) indexing from RPI to CPI. Why? Simply, because this wedge of RPI over CPI means over the long term it is more expensive for the government to pay RPI than CPI. And given the long duration of these liabilities, the present value and so budgetary impact today of such changes are extremely powerful in terms of delivering on austerity. From a rather different perspective, that’s why there has been so much resistance to these changes on the part of public sector workers, amongst others.

The ONS is the body that is responsible for the classification, collection and measurement of these compensation indices – no mean task I hasten to add (see here for a video we did with the ONS last year). We have heard much in research notes and certain press articles in recent weeks about the ONS undertaking a project to eradicate the wedge entirely! What would this mean for us as investors? It would be less attractive to own UK linkers, as inflation as defined by RPI would be structurally lower than it has been. The breakeven rate (the rate between nominal gilt yields and index-linked gilt yields) would fall, meaning that index-linked bonds would underperform nominal bonds. This would be especially so at the long end, where the price or present value impact would be felt most.

I can think of 5 strong arguments against such an assault on the wedge:

1.To eradicate the wedge altogether would be tantamount to an event of default, especially if this is specifically to eradicate the structural difference between the two indices! We bought these securities on the basis that we would be paid RPI, which we know changes in terms of items and weightings on an annual basis, but according to changes in spending habits rather than Government policy. That’s fine! But the index is based on an arithmetic mean and always has been, and so will (almost always!) be higher than an index calculated according to a geometrically calculated mean. To change this, willingly and knowingly, with the purpose of reducing future outgoings of index-linked borrowing cashflows feels very similar to the altering of the War Loan’s coupon from 5% to 3.5% in 1932, or to the Greek PSI exercise of coercive write-downs, neither of which, arguably, were ‘defaults’.

2. The Statistics and Registration Service Act that covers changes to RPI states that any changes to the index must be carried out in consultation with the Bank of England as to whether the changes are fundamental and materially detrimental to holders. If the BoE decides that both of these conditions are met, then the changes to RPI cannot go ahead without prior approval of the Chancellor. Well, given the changes Mr Osborne has been trying to make elsewhere in his search for austerity, might he simply approve the changes in the index? Well this would not be without significant risks, electorally, and it would have a fundamentally and materially detrimental impact on the ability of the DMO to borrow through the linker market, which we will touch on in a moment. But perhaps it would be open to legal challenge? Consideration of this last issue involves looking into the contractual protections embedded within the old-style 8 month index-linked gilt prospectuses. It turns out that these documents state that if both the conditions of a change to the index above are met in the opinion of the BoE, HMT will inform bond holders of this, and offer them the right to redeem their stock. So the next issue for holders is: at what price can I put my bonds? The prospectuses state that “the amount of principal due on repayment and of any interest which has accrued will be calculated on the basis of the index ratio applicable to the month in which repayment takes place”. Thus, in current markets, with substantial negative real yields, the protection provided in these old style bonds is not sufficient to compensate holders fully, as it only pays accrued inflation. As a result of this, holders are going to be very sensitive to any chatter about substantial changes to the index. And this will have pretty major consequences. For instance, looking at the 4.125% gilt linker of 2030, the current price of the bond (given by current accrued RPI relative to RPI at the date of issue, along with future assumed inflation of 3% per year, positive real coupons, and negative real yields) is 316.5. To take this bond and assume we put the bond in the event of a change to the RPI, we multiply par (100) by the index today (242.5) over the base RPI at issue (135.1) to arrive at a price of 179.5. A holder would be set to lose 137 points, or 43% of the bond’s current value!

3. It would also serve to ruin the RPI linker market, at least for a long while. The uncertainty from recent headlines cannot be helping sentiment among the linker buyer base at the moment, and this has been an extremely important source of funding for our high levels of borrowing in the UK in recent years. It would be unwise to annoy these buyers, as it will only serve to increase the costs of issuance (through demanding higher real yields), irrespective of the final outcome of the ONS’ project to lower the paid level of inflation. Indeed, this begs the question as to whether to make the change to linkers from the perspective of our financing position would be to shoot ourselves in the foot?

4. The ONS states on its website under its ‘Vision and Values‘ that: “Our mission is to improve understanding of life in the United Kingdom and enable informed decisions through trusted, relevant, and independent statistics and analysis” (my emphasis added). To target the structural and total eradication of the RPI-CPI wedge would in my opinion clearly be an impeachment of its independence, and would see huge criticism about the political motivations of such a change in the index. This could perhaps lead to legal challenge.

5. Could this not be interpreted as an attempt to specifically and deliberately conceal high levels of headline inflation, Argentina style? Or, if not, to artificially and deliberately manage UK inflation down? It is not just pensions and benefits that are linked to inflation, but wages and commercial contracts, which all have significant impacts on the economy’s overall level of inflation. To change the major index underlying all these contracts from RPI to CPI (the logical equivalent of making RPI CPI) would be to manage inflation down, at a time when so many are concerned about stubborn inflation in recent years, as well as the effects of super-accommodative monetary policy on future inflation. What would this tell us about our politicians’ and policymakers’ inflation targeting attitudes and indeed capabilities?

As a result of these arguments, I personally find it difficult to believe that this is the intention of the ONS or of its project to examine the wedge. I believe instead that the review is targeted at removing some of the anomalous sources of the wedge, which resulted, in no insignificant part, from a change in measurement that took place in 2010 that particularly impacted the wedge between RPI’s clothing price level and CPI’s clothing price level.

Year-on-Year RPI vs. CPI clothing and footwear

Indeed, the clothing and footwear components of RPI and CPI alone represented 60% of the total wedge between the two indices! This kind of change would be justifiable in my opinion. Anything else would at best be ill-advised, and at worst would be mismanagement on a major scale.


Exploding Myths

According to many market commentators, the UK debt market is looking sick and is at a critical juncture. It is amongst the most unloved government markets in the developed world, which is understandable given the British inability to save in the boom times.  Now there is justifiable scepticism that markets will not be able to absorb the forthcoming huge government debt issuance once the Bank of England stops providing life support to the gilt market when it ends the quantitative easing program.

This consensus view is typified in PIMCO’s monthly investment outlook in which the UK bond market is singled out as a market that must be avoided. In their opinion, the gilt market is resting on a bed of nitroglycerin. PIMCO point to the UK’s relatively high level of government debt, potential for sterling to fall and domestic accounting standards that have driven real yields on long dated inflation linked bonds to exceptionally low levels. 
We agree these are issues that face the UK economy and have commented on these points previously. However, like any consensus, it makes sense to investigate if this is correct, priced in, and when it might come to an end.

Firstly, the IMF forecasts that for 2009 that the UK government will have a relatively large annual deficit of -11.5% of GDP, which is below that of the USA (-12.5%) but almost triple Germany’s government deficit (-4.2%). However the UK’s total outstanding gross debt stands at 68.7% of GDP, which compares favourably with the USA (84.8%) and Germany (78.7%). The UK government has responded in aggressive Keynesian fashion to the downturn, if this medicine works then the action will be short term in its nature and will not leave the UK with a permanent debt burden, or the increase in debt could alternately be curtailed by the arrival of a more fiscally stringent government in this year’s election. The UK has very little foreign debt and has been prudent by having the longest maturity debt profile in the G7. Outstanding debt and re-financing needs would therefore appear relatively manageable on an international basis. Not all outcomes will be bad.

Secondly, with regard to fears that our exchange rate could fall, the exchange rate has already collapsed by 22% on a trade weighted basis since 31 July 07.  So a lot of the necessary adjustment has already taken place. This adjustment process is very beneficial for an open economy such as the UK, especially when many of our trading partners are locked into using the relatively strong Euro currency. By having a flexible currency and control over domestic interest rates, the UK is arguably in as good a position as anyone to grow our way out of our debt problem.

Finally, accounting standards have indeed distorted gilt yields as we have previously mentioned here. However, this accounting standard is designed to improve company accounts in terms of disclosing assets and liabilities of company pension schemes and this is surely a good accounting standard that should be adopted by many other regulators. The fact that better pension regulation in the UK results in lower long term rates makes long dated bonds – especially UK linkers – look dear internationally. But this dampening influence on gilt yields is a distortion that is likely to persist unless the regulation and the accounting oversight of this significant employee benefit are changed.

The view that the UK gilt market is one to avoid has some punch in the short term, but the consensus is exaggerating the risks the UK gilt market faces. Even if one agrees with the consensus, it is important to see if this view is priced into markets and when this will eventually come to an end. I agree with the direction of the consensus, absorbing that much new supply will be negative for gilts in the short term. However in the longer term the UK has the chance to adjust to the crisis through fiscal stimulus, financial reform and a falling exchange rate that might well provide the medicine required. The consensus that a bed of nitroglycerin is a dangerous place to rest like any consensus view should be challenged.  Don’t forget, a bed of nitroglycerin could be exactly what the sick UK economy needs as it is one of the oldest and most useful drugs for restoring patients with heart disease back to good health!


Gilt supply update: back to a world of issuance exceeding buybacks

In last week’s Pre-Budget report, UK Chancellor Alistair Darling announced that gilt issuance for the current financial year would total £225.1bn – a shocking and record figure, although not far off the £220bn that was originally planned in this year’s Budget. But while on one side we’ve had this huge volume of supply from the DMO, we’ve also had the unusual situation of the BoE busily mopping up gilts at a frantic pace.  In fact as this chart shows, in Q2 and Q3 of this year, the BoE was actually buying gilts back faster than the DMO could issue them.   This massive demand for gilts has kept a lid on gilt yields – 10 year gilt yields today are where they were at the beginning of June. 

However, the demand/supply dynamic is changing and is set to change further.  Looking at demand, the pace of buybacks has recently slowed considerably, as pointed out by Richard here.  In November, the BoE ‘only’ increased the scale of QE by £25bn  versus a £50bn increase previously, and year to date gilt issuance has once again overtaken the volume of BoE buybacks.  In terms of supply, we still have around £50bn of mainly conventional gilt issuance to come over the remainder of this financial year, followed by another £174bn in the pipeline for 2010/11 and probably a similar amount the following year.

The quantitative easing pressure cooker has clearly kept gilt yields lower than they would have been in its absence, but the worry is what will happen once the lid is eventually taken off.  Who’s going to buy the gilts?  Will the gilt market bubble over and make a big mess?

You shouldn’t underestimate the power of the authorities to find new ways of generating domestic demand  to keep sovereign debt yields yields suppressed, as the Japanese experience of the past decade has shown, and in the UK we’ll see that a significant part of next year’s gilt supply will find its way onto banks’ balance sheets.  But in our view there’s a greater risk that gilt yields will rise from here rather than fall, and the prospect of a hung parliament and the potential for a UK credit rating downgrade increase the risks.


What effect will the surge of government bond issuance have on government bond returns?

This is a question that numerous clients and members of the press have asked us so I thought it would be worth writing a brief comment here. 

Focusing on the UK, in yesterday’s budget, chancellor Alistair Darling said that gross gilt issuance will be £220bn this financial year, which is easily a record. There is much speculation as to whether the market is able to digest this much issuance.  If there is a lack of demand, or ‘indigestion’, then prices will have to fall and yields to rise until appetite for gilts returns.  

The chart shows the relationship between gross gilt issuance in each fiscal year since 1991 against the total return from gilts in that period.  There is no relationship.  It’s also a similar story if you measure gilt issuance as a percentage of GDP, or look at net gilt issuance rather than gross gilt issuance.

A lack of correlation is not to say that it doesn’t matter if the supply of government bonds is huge – clearly it does matter.  The law of economics says that if the supply of something increases, then all else being equal, the price will fall. But with regards to government bond issuance, all else does not remain equal.  When governments issue lots of bonds, it generally means that the economy is in trouble.  And if the economy is in trouble, it means that spare capacity is probably being created because unemployment is going up and wages are stagnant (or perhaps even falling).  These things all put downward pressure on inflation.  If inflation falls and interest rates are low or falling, then locking into a high fixed interest rate (at least ‘high’ relative to cash interest rates) is very attractive, and demand for government bonds increases. Yields therefore fall and prices rise.  This is exactly what happened last year in the UK – 2008 was the biggest year for gilt issuance but was still a very good year for gilt returns.

What will cause demand for gilts to rise over the next year to equal or exceed the supply of gilts?  It depends on what happens to inflation and economic growth.  In terms of inflation, Alistair Darling  projects CPI to fall to 1% this year, and RPI to fall to -3% in September before rising to zero next year.  In terms of growth, he expects -3.5% for 2009, +1.25% for 2010 and 3.5% for 2011. 

Slightly ironically, gilt investors should be hoping that the chancellor has overestimated his growth forecasts, even though this will inevitably result in the budget’s numbers not adding up and even more gilts being issued than projected.  Gilt investors should hope Alistair Darling is wrong because if the chancellor is correct about +3.5% growth in 2011, the economy will be booming at its strongest pace since 1999 and you can be pretty confident that government bond yields will be quite a bit higher. 

Much can happen between now and 2011, and his growth projection is certainly possible, but at the moment our view is that it is unlikely that UK growth will be this strong.  If UK economic growth does indeed fall short of his projections, then it’s also likely that inflation will fall short too.  And if your core scenario is that sterling won’t collapse (which would put upwards pressure on inflation), then gilt yields are very capable of going lower.

Finally, as we’ve mentioned previously on this blog, don’t forget what happened to Japan.  There are of course many differences between the UK and Japanese economies, but an important lesson is that large issuance doesn’t mean government bond yields must rise.  The OECD expects Japan’s ratio of public debt to GDP to rise to 197% next year, more than two times as much as for France, Germany and the UK (see chart).  Japanese government debt has tripled since 1996.  And yet today, 10 year Japanese government bonds yield 1.4%, and got as low as 0.4% in 2003.


Rapid changes in life expectancy will continue to drive the bond market

Life expectancy isn’t just increasing, the rate of change is actually accelerating, thanks to rapid medical advancements. Great news for humankind, great news for owners of long dated bonds, but a nightmare for pension funds.


Recent research from Paternoster, a company that buys up final salary pension fund schemes, has published a report estimating that if life expectancy continues to increase at its current rate, pension funds will be in deficit of £175bn (Life expectancy – has everyone got their numbers wrong?). Even if the rate of change slows, pension fund liabilities will still exceed pension fund assets by around £75bn.

Any increase in pension fund liabilities means that companies will need to increase pension fund assets, and long dated bonds are the best assets to match with long term liabilities. The total supply of gilts maturing in at least 25 years is only £74bn, and this huge demand/supply imbalance should continue to support long dated bonds.

You might like to also take a look at Jim’s recent article Longevity starts to worry the actuaries.