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Our views 31 October 2022

JP’s Journal: The UK yield premium

5 min read

We can all probably agree that the recent political shambles has reflected badly on the UK. However, let me try to put it into perspective.

If we look at markets over a six-month period – to capture the embers of Boris Johnson, the Conservative Party election process and the implosion of Liz Truss’s government – we can see that market repricing is a global event. UK 10-and 30-year gilt yields are up 150bps, whilst real yields have risen more. In the US, the increase in nominal yields has been around 120bps with a similar rise in Germany and France. Again, real yields in these areas have risen a bit more than nominal rates. So it looks like we’ve seen a 30bps premium for UK government bonds as a result of the political turmoil. There may be a lot of other factors at work, but I think that recent events have given the UK a higher risk premium.

Is this just the UK?

The question is whether this is justified. There is always the temptation to be self-critical. Yes, there is no hiding from the turmoil we have gone through. But let’s look through a different lens. The UK’s constitutional arrangements have worked. We have transitioned smoothly to a new Head of State, there has been no storming of Parliament and political discourse remains, generally, civil. Contrast that with the US, where in recent years the Legislature has been violently stormed, where political debate is malicious and the right of the President to exercise executive powers is disputed. And this is before mid-term elections which may usher in two years of paralysis in government.

In recent years we have seen the UK setting trends that others follow. What we have just seen is a clumsy attempt to confront deep seated economic problems. The transition to a higher interest rate regime, coupled with inflation and slow real economic growth will dominate global politics for a long time to come. Perhaps our institutions may cope with this better than others – let’s see.

The challenge in the eurozone will be to keep countries towing the same line. This will not be easy as populist parties gain ground in some areas. We are already seeing challenges in Italy to the European Central Bank’s (ECB) intention to tighten policy. So last week’s 75bps rate hike and signal of further moves will only add to the tension. The ECB remains of the view that euro area inflation is far too high – exemplified by German inflation now exceeding that of the UK. With warnings that it needs to guard against the risk of a persistent upward shift in inflation expectations, it is clear that the hawks are in control – despite the dovish spin playing out in markets.

UK bonds see rebound

Looking at last week’s moves we can see that there was a big move down in UK government bond yields and whilst the trend was mirrored in other markets the change was greatest for gilts, where 10-year yields finished below 3.5%. Real yields rallied strongly, moving close to zero in many maturities. This reflected the fiscal orthodoxy outlined by the new Prime Minister and a bounce back from the 'collateral selling' endured in recent weeks.

Sterling credit markets also saw an improvement. This can be measured in serval ways. At an index level, the yield premium over government bonds contracted, although still towards the higher end of the 2022 range. Dealing costs came down a bit more – but are still above levels seen a few months ago. We continue to see buying of higher quality and longer dated debt as pension funds look to take advantage of the higher 'all-in' yields. Indeed, one of the trends I expect to see through 2023 is the move to reduce risk (through the buying of publicly quoted bonds) for those funds where the move up in government bond yields has been a real positive.

To end on another observation. When I woke up on the 26 September, the radio headlines were about sterling trading at 1.035 USD – a sharp fall in Asian markets reflecting a loss of confidence in the UK. In the following days, the UK was compared to emerging markets with several forecasters expecting an imminent fall to parity. Let’s be clear, I am not a currency analyst and my record, when pushed, has been poor. But the UK is not like an emerging market and such comparisons reflect poorly on the quality of the analysis undertaken. Certainly, from my parochial viewpoint, I would ask of detractors: “Why do you note the splinter in your brother's eye and fail to see the plank in your own eye”. UK assets look cheap to me.


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