I had my third (booster) jab this week – which was timely given the news about a new Covid variant. This impacted financial markets pretty severely on Friday. In the UK 50-year rates dropped towards 0.75%, close to the year lows. In the US 30-year rates closed in on 1.8% and German long-dated bonds flirted with zero rates.
Let’s just think about those rates. Investors are lending to the German government to receive no return, if held over the next 30 years. No one would actually do that unless there was an expectation that a buyer will pay a higher price at a future date or that prices will fall, giving rise to a positive real return. Admittedly, liquidity may be parked in these bonds awaiting a repricing of other asset classes, but a 30-year bond is a strange place to keep such cash. In the UK, 50-year bond yields are still 30bps above the lows of last year but we were not thinking about inflation at that point. Today, we have Consumer Price Index (CPI) inflation above 4% and term structures reflecting interest rates around 1% over the medium to long term. In the US the number is nearer 2%.
These low rates did not put off buyers. Last week saw the launch of a new 50-year index linked gilt; it was sold at a yield near -2.4%. Instead of being issued at £100 the bond was sold at a price of just under £360 with a real coupon of 0.125% – it is only by issuing at this price that a coupon could be set. On Friday the bond moved up and hit a price of £390, a high annualised return for the risk-free rate! Looking at it another way: if the Bank of England (BoE) is successful in its remit of 2% CPI inflation (leaving aside distortion between CPI and RPI (Retail Price Index)) holders of the bond will receive less than £300 back.
I may sound like a broken record but real yields are the key to markets. Yes, equity and credit markets sold off on Friday but unless real yields rise, equity and credit ‘bears’ will be disappointed. Of course, Covid variants may be more disruptive, which may make the positive case for risk assets more difficult to sustain but intended monetary policy tightening will be delayed. Perversity may prevail but given news flow it is difficult to see the BoE raising rates this year, given the uncertain background and the ‘missed’ open goal presented in November.
Talking about open goals – is the Government doing the right thing considering a Football Regulator? It appears that the Big State elements in government are driving this. Let the private sector flourish unless there is a need to address abuse. Football, and the English Premier League especially, is a great example of how private business can thrive. We have the best players, best managers, some of the best grounds and a product that is truly global. Perhaps that’s the problem: politicians often try to use football for political purposes and maybe this is a government that wants reflected glory.
Government bonds and cash
Yields on 10-year UK government bonds finished the week at just above 0.8%; it was only last month that this rate was at 1.2%. The economic news, outside Covid variant speculation, was mixed. The US Purchasing Managers' Index (PMI) looked consistent with softer growth and was held back by supply chain problems and labour availability. Services, in particular, surprised on the downside. US business optimism rose though, in contrast to the European PMIs. US employment data dipped a touch but is still at relatively high levels. Uncertainty about Covid may impact thinking but the labour market looks consistent with tapering to my mind.
Euro currency weakness continued last week with the threat of further lockdowns dominating news flow.
The new index linked gilt was a runaway success with an allocation rate of 12% on orders; I think this was a record low. The real yield hit -2.56% on Friday which contrasts with a yield of 3.5% on UK shares. One of these is wrong: a 6% differential is not sustainable. Either real yields rise, the UK equity market goes up or we get significant dividend cuts (or a combination of these).
High yield was the main casualty in credit markets last week with my favoured index showing a credit spread rise of 50bps. It has been quite a turnaround in recent weeks with current spreads about 1% higher than their summer lows. Whilst emerging market debt has been at the epicentre of the move there have been signs of a widening, with developed market high yield suffering in the latest move.
In sterling investment grade markets, spreads were about 10bps wider, although high beta names suffered more. We continue to like subordinated financial bonds but they have given ground in recent weeks. Conversely, our asset backed securities have generally held in well and overall relative performance has not been hit too badly.
The big question is where real yields go from here. We stick to our view that terminal rates, as implied by curve yields, are unduly pessimistic about growth and that there is an inherent contraction between implied inflation and nominal rates. Put another way, I don’t think long real yields will stay at -2.5% in the medium term.
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