The astronomical autumn, defined by a 23.5 degrees tilt of the earth’s rotational axis in relation to its orbit around the sun, officially began on 23 September this year.
That seasonal shift loosely coincided with another, an about turn in UK economic policy in the form of a massive new package of energy support that could cost up to £200 billion; the household price cap scheme, which is due to last for 18 months, is estimated to cost around £120-140bn and a corporate support scheme could add another £60bn or so.
Capping energy prices through a government subsidy should serve to dampen inflationary pressures in the near term and this will be a source of great comfort to British households this winter but for investors in UK government bonds there’s a sting. A potential £200 billion of extra gilt issuance, over this fiscal year and next, risks coinciding with the Bank of England’s (BoE) own plans to sell some of the bonds it had built up during the years of quantitative easing, when it amassed £895 billion of assets to stimulate the economy.
Gilt prices have taken a tumble
In the government bond markets, prices have already begun to tumble. 10-year gilt yields, which were at around 1.8% at the end of July, climbed to around 3.0% by the middle of September. The cause of this development has been the evaporation of investors’ hopes that central banks would pivot away from a focus on controlling inflation, to concern about the economy. We believed that this was always an unlikely scenario, given the runaway inflation backdrop, and had taken the opportunity to sell some bonds at higher price levels when they were offered.
Even as headline inflation slows, as seen in the August data, we would expect the BoE to continue to raise interest rates. The market is currently pricing-in a further two percentage points (+2.0%) increase in base rates before year end. This will maintain pressure on bond yields. As bonds have cheapened, we have started to rebuild our bond holdings, although overall exposure remains well below levels seen in 2018.
From where will bonds take their lead
The conundrum that is now facing the market (and us) is which outcome of the UK policy will dominate bond prices. On one hand, the significant lowering of inflation expectations through the price cap, which could knock as much as five to six percentage points off inflation over the next two years, will reduce the urgency of future rate rises from the Bank of England to combat inflation. On the other hand, you have the unknown effect of the huge net gilt issuance required to pay for this largesse.
As always, our approach is to proceed with caution and remain dynamic, ready to adjust the portfolios based on new information in the marketplace. Volatility will clearly remain elevated in the fixed income markets for some time to come, which will offer opportunities for both profit and protection.
