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Our views 06 June 2022

JP’s Journal: It’s about real yields

5 min read

The BBC really does not get finance and business reporting. Listening to the business slot on Radio 4 last Wednesday morning, it was apparent that they had missed the big news of the previous day.

Yes, they do have economists on their programmes and sometimes even a bond manager – but the usual questions focus on consumer stories, sometimes with an equity slant. And, in some respects, this is understandable. Who wants to talk about yields, implied inflation, corporate bond spreads and government debt when we can hear about troubles in the airline industry and long queues to get away at half-term. A 20% slide in Tui share price in six months, as reported on the show, was not really a big story.

The FT, on the other hand, has no excuses. Its cover stories on Wednesday were about an EU-UK insurance pact and AC Milan; the Markets section covered Unilever as its main item. Fair enough, developments at one of the UK’s largest companies is worthy of reporting… but AC Milan on the front page?

So, what has got me agitated? Well, last Tuesday was one of the most important days in bond markets for a long time and the ramifications will feed through the valuation of all asset classes over time. This should have been the lead for a financial orientated paper. Come on guys!

Real yields matter

I know I may sound repetitive but the major story of last week was real yields. On Tuesday the longest dated UK index linked bond fell 10% in price. Yes, ‘the risk-free real asset’ collapsed. A bit melodramatic on my part but it felt that way. On a six-month view the rout is even more evident: the index linked 2073 gilt traded yesterday at a price of £180, compared with nearly £400 in November 2021. It has underperformed Bitcoin over this period.

This is not just an issue for real yield nerds like me. It is the discount rate against which all financial assets are assessed. Naturally, the US real yield is the global rate, and the UK rate is adjusting from being out of line but the trend everywhere is for higher real yields. In the UK, the longest dated bond has seen the real yield go from -2.6% to -1% in six months; in the US the longest index linked treasury bond has seen its yield rise 130bps. This is the massive story for financial markets last week; it makes all other asset classes less attractive.

Markets

Equity markets were pretty sanguine with most broadly unchanged. Perhaps the FTSE 100 took comfort from the UK the latest government package to alleviate the cost-of-living crisis. But this support (0.6% of GDP) makes further rate hikes more likely. Markets are factoring in rates of around 2.75% in 12 months times. It is possible that the Office of National Statistic will treat the energy bill discount as a price cut, lowering the Consumer Price Index (CPI) inflation expected in Q4. Helpful but not sufficient to stem the energy hikes likely later in the year. In the US the Federal reserve signalled of a couple more 50bp rate rises and re-iterated the commitment to achieving 2% inflation. With core CPI above 6% the market is factoring in short term rates of 3% within a year.

The rise in real yields fed through to nominal rates. Yields on US 10-year treasuries moved back towards 3% whilst the UK equivalent moved decisively above 2%, starting this week nearer 2.2% – a near 50bps hike in two weeks. In Germany 10-year yields hit 1.25% whilst Italian yields moved above 3.3%. Implied inflation moved up a bit in the US but was not much changed in the UK.

Credit markets, like equities, were largely unmoved by the change in real yields. High yield spreads continued their recent tightening and there was renewed demand for investment grade credit at these wider levels. New issues were better received and there was an improved tone to financial bonds, a consistent underperformer in recent months.

The truncated trading week in the UK allowed us to recognise the Queen’s 70 years of tremendous dedication. Sometimes I think we take for granted the stability this has brought to our political system. What the Queen does represent is an ability to adapt to changing times – just comparing 1952 to 2022 shows the vast changes that have been witnessed. What we must not do is develop a nostalgia for the past that obscures the challenges of the future. Revisiting imperial measurement is no substitute for real policies aimed at addressing the headwinds we face. Whoever is Prime Minister in a month’s time will face a difficult economic situation.

 

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.