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Our views 23 October 2023

JP’s Journal: Gilts and kilts

5 min read

Events in Israel and Gaza continued to dominated news flow last week. We live in an information age where horrors are immediately transmitted around the world. But at the same time the manipulation of what we see becomes more sophisticated – so we become unsure of reality.

This suspicion ingrains prejudices and promotes alternative narratives. Disturbances in Lebanon, Jordan, Turkey, and the West Bank following the explosion at the Al-Ahli Gaza hospital, and the aggressive comments from Iran, indicate that appearances matter. This is why the US is both supporting Israel but also urging caution. The shuttle diplomacy of Secretary of State Blinken and the comments from President Biden about what the US did wrong in the aftermath of 9/11 suggests that the US favours Israeli restraint.

From a market perspective the worsening situation has not translated into risk-off trades. The oil price has risen but is still below its late September peak. The US dollar has not rallied and there has been no rush to buy US treasuries. Gold has proved an exception but its recent spike has been from a year low and is well below its April high. Equities have held in, helped in part by strong relative performance from energy. As an aside, this may explain why some ESG equity funds are seeing performance challenges.

The paralysis within the US Congress continued with the latest Republican contender for Speaker, an ex-wrestling coach, being rejected. This is not helping the treasury market, although deeper trends are playing out. As always, there are plenty of reasons why an event has happened but it boils down to investors adjusting to a higher real yield world, hence the steepening of government bond curves. Why is this happening? The US debt mountain, massive capital investment needed to support climate action and carbon reduction, more Asian money being kept at home to build domestic infrastructure, less Chinese recycling of dollars into treasuries, a more general theme of de-dollarisation in a fragmenting world. These trends seem structural but give little insight into timing or a clearing level.

Let’s look at the move in US treasury yields in a bit more detail. At the end of June, five-year yields were around 4.2%, with 20-year rates at 4.1%, a slight inversion. Today, the respective yields are 4.8% and 5.3%. Part of the move at longer maturities reflects higher inflation expectations but the main driver has been the change in real yields: 1.7% to 2.6% on 20-year treasury inflation-protected securities. This is not just a US phenomenon; in the UK, we can see a similar pattern, even if real yields are at lower levels.

The UK’s public finances surprised last week – with the borrowing level being less than expected. This has given rise to speculation that tax cuts could be back on the agenda, with stamp duty being put in the spotlight. This is a bad tax – certainly the level applicable to housing transactions. It discourages transactions and mobility but does raise considerable money, over £15bn from all sources. Some shift to a tax system less based on transactions would be economically desirable but the political will is lacking to redraw the rules to tax property values more. Further tinkering with support for first time buyers is also being mooted – another bad concept. If the Prime Minister, Rishi Sunak believes in planning for the long term this should be kicked into the long grass. The economic illiteracy of boosting prices at the bottom of the housing ladder is staggering.

Gilt yields ignored the better deficit data, with rates mirroring the global trend. The latest inflation data was a tad disappointing, with the Consumer Price Index coming in at 6.7% and service inflation at 6.9%. Not enough for the Bank of England to change course, but focusing greater attention on next month’s release where a big drop is forecast. Bad news on that would lead to investors questioning the peak rate consensus. Yields on 10-year gilts ended at just below 4.7%, 25 basis points (bps) higher on the week. Investment grade credit spreads inched wider whilst high yield moved more significantly, closing 50bps higher on the week.

On a different note, apologies to my colleague Craig Inches for this plagiarism, but I could not resist his take on the naming conventions for Scottish government debt, heralded at last week’s Scottish National Party conference: Sporrans (short dated), Kilts (mediums) and Trews (longs). As a Scotsman, Craig is better placed than me to offer up such tags and we may well get the opportunity to road test if the plans go ahead. The Treasury’s take on this is that such issuance will not be guaranteed by the UK government. So, Kilt yields would be determined by the perceived creditworthiness of Scotland. The independence movement may have lost momentum recently but establishing a cost of finance would be a major step in making a financial case.

To end on the rugby. England played magnificently but in the end the South African scrum told. There was a lesson to be learnt – referees rarely welcome dissent. A leaf out of Bobby Charlton’s book would have been welcome. He was a true sporting great – both on and off the field.

This is a financial promotion and is not investment advice. 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.