The continued negative correlation between GBP weakness and Gilt yields is a threat to the UK economy as it at least in part negates the expansionary effect of BOE monetary easing and indeed of GBP weakness. It may also lessen the ambition of the UK government to initiate a much-needed fiscal stimulus. This is concerning since the UK economy is particularly ill equipped to withstand the Brexit shock. Households – the core driver of the post-GFC economic recovery – face the shock with a weakened balance sheet: nominal wage growth remains weak, and rising inflation will squeeze disposable incomes; households have rapidly increased leverage in recent years; flow of funds data shows UK households to be dis-saving at a rate last seen on the eve of the GFC.
In terms of the drivers of Gilt weakness, the variable we are least worried about is the concern over inflation. While higher import process will see the CPI exceed the BOE’s 2% inflation target, insufficient wage growth will mean this poses more of a threat to growth than to medium-term inflation. This is a story of FX and commodity price shock to headline inflation that we have seen play-out many times in G10 economies over the past decade. Now is no different. BE inflation spreads have already widened to the point where they significantly over-state the likely path of inflation. Similarly, concerns about the impact of a foreign investor flight from Gilts may prove over-stated. However, while we have maintained our bullish medium-term forecasts for Gilts, any near-term appetite to fade the rise in nominal yields is tempered by an understanding of how it may take some time for the market to recognise that the current inflation scare is over-stated and also by the emerging signs that the government may persist in its recent criticism of the BOE’s loose monetary policy. The latter poses a particular threat to the Gilt market, and ultimately the GBP and UK economy, if it reinforces the increasingly common – and persistently incorrect – viewpoint that the UK requires tighter monetary policy.
Part 1 – The drivers of the Gilt sell-off
The GBP sell-off has morphed into a Gilt sell-off. Yields have surged beyond the levels seen when the Bank of England (BOE) relaunched QE and lowered interest rates in August in light of the Brexit shock. (Chart 1.) While at 1.08% 10-yr Gilt yields remain 40bp below the levels that prevailed on the eve of the Brexit vote, they are 46bp above the recent lows. The Gilt sell-off has been driven by a perfect storm of adverse developments and a changed market focus:
Chart 1. The Gilt market sell-off has retraced the QE gains
Source: Bank of England
- Inflation outlook. The GBP collapse has also a surge in inflation expectations that has seen the market price-in the need for higher real yields and tighter Bank of England (BOE) monetary policy. Breakeven inflation rates have surged (Chart 2.). The BOE’s own econometric modelling assumptions support the rise in inflation anxiety: the BOE assume that 20-30% of the move in the GBP TWI tends to be embedded in the price level; with the 18.9% slide in the GBP TWI since the Brexit vote, that would imply that the level of headline inflation could be 3.8-5.7pp higher as a result. Of course, as we will discuss below, inflation concerns in the UK are significantly over-stated, but for now an upsurge of UK inflation is a driving meme of the moment in the Gilt market.
Chart 2: UK Linker Break-even curve (%)
Source: UK DMO
- Monetary policy outlook. Aside from the impact on inflation expectations the slide in the GBP is prompting a growing number of market participants to believe that BOE will focus more attention on stabilising the currency and tighten monetary policy. The outlook for monetary policy is further clouded by the public criticism of the BOE’s loose monetary policy from the UK government.
- Concerns of a foreign capital reflux. Foreign investors are a critical component of the Gilt market. (Chart 3.) In Q2 2016, overseas investors held 26.9% of outstanding Gilts (of which central banks held 4.4%), making them second only to insurers and pension funds (27.1%) and above the BOE (23.0%). The market is concerned about the durability of this overseas exposure given the heightened policy and political uncertainty in the UK. The BOE has provided the requisite adult supervision among UK policy-makers since the Brexit vote, and yet has been criticised for it’s monetary policy. Within the government, there is a lack of a cohesive agreement on what constitutes a successful Brexit, let alone a clear path to such an outcome. Beyond economics, the politically contiguous concept of the UK as a state is also being questioned anew as the Scottish National Party lays foundation for a second independence referendum Given such uncertainty, there is clearly a concern that Gilts lose their appeal to those international investors who view the UK as offering diversified, safe-haven duration in global portfolios.
Chart 3. Ownership structure of Gilts
Source: UK DMO
- UK equity markets have performed strongly. Gilts have not even been able to benefit from safe-haven flows within UK asset markets. Buoyed by the translational effect of a weaker GBP on the GBP earnings outlook for firms with an international exposure, UK equities have – for now – performed strongly since Brexit.
Part 2 – The UK is poorly equipped with withstand a Brexit shock
UK still needs a 2% of GDP fiscal stimulus
The surge in Gilt yields is adding to the mounting downside risks to the UK economy. Our base assumption has been that absent a notable policy response, the 12-18 month impact of Brexit will be a 3pp swing in GDP growth, from ~2% to -1%. The BOE offset some of these downside risks when it eased monetary policy in August, which provided a sentiment boost that helped prevent immediate post-Brexit concerns disrupting investment and consumption plans and which supported risk markets. The BOE’s contention that it’s post-Brexit monetary response prevented a 400-500k rise in unemployment (which would be the equivalent of pushing the current 4.9% unemployment rate back above 6%) rings true.
Gilt selloff reduced impact of BOE monetary easing and could limit the appetite for fiscal expansion
However, the impact of QE in supporting growth is being undermined by the recent surge in Gilt yields, which comprise a tightening of financial conditions that can also offset the expansionary aspect of the weaker GBP. Equally alarming would be if the rise in Gilt yields reduced the government’s appetite for counter-cyclical fiscal stimulus during the November Autumn statement. We continue to believe that the Chancellor needs to implement a fiscal easing amounting to ~2% of GDP, but the prospects of such a stimulus are fading.
UK households enter the Brexit shock with strained balance sheets
An insufficient policy stimulus is particularly worrying in the UK given how poorly equipped the country is to withstand an external shock. In particular, consumers – the cornerstone of the post GFC economic recovery – have very strained balance sheets:
Laggardly wage growth increases the economic his from higher import prices
Like the rest of the G10, UK wage growth has been anaemic in recent years. Since the GFC the recovery in the UK labour market has been particularly brisk. Unemployment fell to an 11 year low of 4.9% in June despite a stable participation ratio (63.7% in June vs. 63.6% at end-2007), which implies a pronounced phase of job creation. Despite this, average earnings rose just 2.3% Y/Y (3mma) in July, compared to an average of 4.3% between 2000-2007. (Chart 4.) Weak income growth increases the vulnerability of households to external shocks, particularly lower-income earners who will feel a disproportionate impact from the GBP-related rise in import prices for non-discretionary consumption items.
Chart 4. UK wage growth remains laggardly despite a tight labour market
Unlike in the US, UK households have releveraged …
One of the features of the UK economic recovery since the GFC was that weak income growth failed to provide a notable drag on consumption activity as households instead releveraged. While this supported economic activity in recent years, it has added to the present vulnerability of household balance sheets and also reduces the potential multiplier effect from BOE monetary easing since households may find it more difficult to expand leverage further into uncertain times in response to lower interest rates. Chart 5 shows a surge in net lending to individuals over the past few years. While government policies aimed to support the housing market such as the funding for lending scheme helped spur fresh leverage in the housing market, consumer credit has also been on the rise and is growing faster than it was pre-crisis. While the growth of credit remains below the levels seen pre-crisis, the increased leverage heading into an event shock to the UK economy is not a trend that will help demand remain resilient.
Chart 5. UK net lending to individuals has surged in recent years
…and are dis-saving as they did pre-GFC
Flow of funds data shows that at a balance sheet level, UK households have been dis-saving in recent quarters. Chart 6 shows how the accumulation of financial assets is being outpaced by the growth of financial liabilities. This trend contrasts sharply with the US where post-crisis there has been a structural rise in household savings rates. This was a trend that prevailed in the UK during the build-up to the GFC and which increased the vulnerability of the UK. The weakness of UK household balance sheets means that BOE easing – rather than spurring fresh consumption – may be more important in averting/ slowing the scale of household deleveraging.
Chart 6. UK households are dis-saving, as they did pre-GFC
Part 3 – How to break the negative correlation of the GBP to Gilt yields
Outside of a one-time shock, inflation concerns likely to prove misplaced
One of the drivers of the move higher in Gilt yields – inflation fears – is unlikely to be a persistent driver of the market. If anything, break-even inflation rates have reached levels where investors could consider fading the recent widening. This reflects two factors.
Chart 7: UK headline inflation is poised to rise sharply
Lower than assumed pass-through of GBP TWI weakness to inflation
Firstly, as the BOE itself has noted, the inflation pass-though effect from a weaker GBP to headline inflation tends to be far lower than the 20-30% assumed in the Bank’s model. While inflation will clearly rise, and over the next 12-18 months, headline inflation is likely to breach the BOE’s 2% target, the pass-though will be far more muted than feared.
Without wage acceleration, an import price shock if negative for growth more than a threat to price stability
Secondly, and even more crucially, the pass-through from imported prices to underlying core inflation will be muted. This will allow the BOE to again look through the rise in headline inflation just as it did in 2011. Higher import prices tend to be more a negative for economic growth than a medium-term threat to price stability if they are not combined with a rise in wage growth. With UK wage growth so laggardly despite a strong labour market and extended period of economic growth, it is difficult to see wage growth accelerating in the current climate. The gyrations of headline inflation will provide little guide to how underlying inflationary pressures will evolve and the BOE would be correct in looking beyond the forthcoming rise in the CPI beyond it’s 2% target when setting monetary policy. (The CPI could exceed the 2% inflation target by more than 1pp within 12 months.) In fact, without a notable second round inflation effect, a 12-18 month surge in headline inflation will beget a similar period of headline disinflation of not deflation as base effects work through the system, particularly as UK growth weakens into 2017.
Chart 8: GBP Trade weighted index
Source: Bank of England
The lessons of the past decade have been forgotten
In making the last point there is an element of deva-vu. Over the past decade or more – when there have been numerous FX or commodity price related import price shocks to G10 economies – there have been frequent instances of intense inflation concerns prompting widespread calls for policy tightening at a time when medium-term inflationary pressures were actually declining. The most extreme case was the truly surreal period between the Bear Stearns and Lehman Brothers collapses, when the market was focussed on the inflation risks of rising oil prices. The market priced in Fed policy tightening and even Fed Governor Bernanke turned hawkish. All this, despite it being abundantly clear that a potential extinction level event for the global financial system was approaching.
“Doing a pre-Draghi ECB” is not a compliment
In contrast, the ECB’s rate hikes in 2008 and 2011 in the face of high headline inflation, demonstrated both a simplistic expression of it’s own policy framework, and also represented policy changes of the highest folly. For the BOE to hike now based on imported price gains that are unlikely to have notable second round inflation effects and which will add to an already darkening economic outlook, would be a case of “doing an pre-Draghi ECB”. The Gilt sell-off represents an over-shoot based on inflation, growth and policy concerns, as does the widening of break-even inflation spreads.
Foreign capital reflux
Equities outperforming Gilts provides an asset allocation risk
Another risk to the Gilt market that we are relatively relaxed about is the potential for a sizable outflow of foreign investors. Admittedly, the out-performance of UK equities over Gilts does risk increasing the sensitivity of Gilt yields to capital outflows from the UK. Under normal circumstances, if foreign investors sell GBP assets, as long as the BOE does not intervene in the FX markets, the new holders of this GBP liquidity will need to reinvest the funds GBP denominated assets. The impact on Gilts would be sensitive to the marginal propensity of the seller of GBP assets to hold Gilts vs. the new holder of the GBP liquidity. However, with Gilts under-performing equities, there is the danger that those foreigners investors that sell Gilts will see their GB liquidity to investors more inclined to allocate funds to GBP risk vs. risk-free assets.
Nonetheless, some of the factors that offset our concerns on this risk include:
- BOE QE. The BOE’s expanded policy of QE will see it purchase another, 3.2% of outstanding Gilts taking it’s share of holdings to 26%, other things equal. This means that QE can offset a sizable reduction of foreign investor selling. Of course, this would still be negative for economic growth as BOE would be limiting the rise in yields rather than driving yields lower, but official buying support does lend itself to limiting the scale of further Gilt sell-offs.
- The anchor of the carry and slide. Bond market sell-offs can be brutal as positions are unwound into markets that are increasingly shorn of risk capital. However, one supportive mechanism for the market would be if the BOE can anchor expectations that it’s monetary policy framework is unchanged and that policy rates will be stable if not lower. If this occurs, then a Gilt sell-off will take the from of a bear steepening and will result in increasing carry costs to be short/ opportunity costs for being under-invested. This tends to provide the force of gravity that limits bond sell-off if there is sufficient belief that policy will be unaltered.
- Scale of foreign selling. Foreign ownership of Gilts has been trending lower from a Q1 2013 peak of 31.2% of the market, and the uncertainty surrounding the UK suggests that it is entirely possible that the coming quarters see a sizable absolute and relative decline in foreign holdings. Around the time of the taper tantrum, Q2 and Q3 2013 saw a record net GBP38bn decline in foreign holdings of Gilts. A similar sized reduction of foreign holdings would mean a 2.1% decline in foreign holdings, less than the BOE will purchase. Plus there are reasons to suspect that despite the manifold uncertainties in the UK, foreign investors might be relatively slow to exit the Gilt market. Gilts are a relatively high yielding, G10, risk-free collateral asset, and unlike non-core European bonds do not incur a credit risk consideration.
- Financial repression. The on-going path of regulation is leading to further requirements for banks to accumulate capital and liquidity buffers. This is maintaining the structural demand for bank to purchase risk free assets. Chart 3 above grows that monetary financial institutions (banks) held 8.4% of outstanding Gilts in Q2 2016 compared to being short pre-crisis. As Basel III and MiFID II advances, demand for risk free assets from banks is expected to increase.
- Equities and growth. The strength of UK equities reflects the positive translation effect of a weaker GBP bolstering the local currency earnings of listed multi-national companies. This is posing an asset allocation risk to Gilts. However, given the deepening economic downside risks to the UK economy, it is difficult to be confident that the equity market will remain so resilient.
Political interference in monetary policy
Tighter monetary policy – a new Conservative Party meme?
Potentially, the most durable and certainly the least predictable threat to Gilts, is the fear that the government will continue to opine on the conduct of monetary policy and state the case for tighter policy. Criticism of the BOE could become a Conservative party meme. Following PM May’s criticism of loose monetary policy, former Conservative Party leader and foreign secretary – William Hague – has penned an article stressing that monetary policy has a clear political component to it and that the world and the UK require tighter policy.
A pyrrhic GBP bounce
Near term, these comments will increase concerns that BOE Governor Carney will not, over the coming weeks, announce that he remain in office for his full 8 year term. Were this to occur, the market would focus on the risk of an appointment being more in-tune with the government’s views on monetary policy. Such an outcome would embed a risk premium in all UK assets. Even any relief that the GBP received from expectations of the BOE focussing more on the currency than the needs of the domestic economy would likely be pyrrhic: inappropriate monetary settings that increase economic weakness ultimately add to the downside risks to a currency.
BOE will resist, but the headline risk is acute
We are confident that government pressure on the BOE will come to naught, but the risk of unwelcome headlines over the coming weeks is substantial. We reiterate that one way to end these concerns would be for the BOE to ease monetary policy. Although the suggestion draws quizzical looks from investors, November’s BOE meeting might be more “live” than the market supposes: BOE reducing it’s policy rate to it’s assumed zero bound would ease concerns over political influence and would be consistent with the BOE’s own economic framework which suggests there is room for more stimulus and which will look through the GBP weakness. If not November, an ease over the coming months looks increasingly likely if our concerns on the UK’s economic outlook prove accurate.
One BOE’s path to stabilising Gilts is via inaction
By dulling the impact of monetary easing and threatening to pare-back the level of forthcoming fiscal stimulus, the rise in Gilt yields roses a notable threat to UK economic growth. This is particularly alarming given the vulnerability of the UK to the economic dislocations of Brexit, particularly in the household sector. However, the optimal policy response from the BOE is to focus its monetary policy on the needs of the economy and medium-term inflation expectations. This requires stridently opposing government criticism of its monetary stance and making it clear that the GBP is an exogenous variable into it’s decision making process, not an endogenous target.
The inflation surge will pass
In the BOE’s favour is the fact that many of the factors driving Gilt weakness, such as the mounting inflation fear and concerns over foreign capital reflux, are likely to prove misplaced. Indeed, the current upsurge in inflation fears certainly rhyme with similar incidents in the G10 over the past decade, all of which have failed to interrupt the underlying medium-term rend of lower inflation. Weak growth not high inflation is our greatest concern for the UK economy. We expect these fundamental forces to re-exert their hold on the Gilt market and retain our medium-term view of substantial downside potential for Gilt yields.
The political pressure on monetary policy is a new and unwanted variable
However, while we are itching to fade the Gilt sell-off, certain factors provide us with caution. Firstly, Gilt market sell-offs are prone to notable overshoots. Secondly, the examples over the past decade of the market gathering a head of steam over imported inflation risks have often been associated with bond market sell-offs that can persist for some weeks. Thirdly, we are increasingly concerned about the continued government criticisms of the BOE’s monetary stance. At best, this comprises a potential source of adverse headlines that could hit Gilts. At worst, they could encourage Governor Carney to stick to his original plan and leave the Bank after only 5 years of his 8-year term. We are confortable that BOE will retain its independence and retain its analytical framework for conducting monetary policy, but the potential noise from the government is sufficient to reduce our confidence in fading the Gilt sell-off at present.
Short break-evens may be an appealing first foray into fading the sell-off
Given that we expect 10yr Gilt yields to drop below 0.50% over the coming 12 months, it is appealing to buy Gilts at 1.08%. However, the uncertainties noted above make us believe that the entry point is one of timing rather than level. We would feel more confortable buying Gilts even at less attractive levels were the government to clearly cease its criticisms of the BOE, than we would at higher yield levels with current risks being maintained. A better first foray in to fading the market may be via the inflation break evens. From 5-years and out. The surge in break evens can only be validated by a sustained rise in inflation, which seems unlikely, despite the continued downside risks to the GBP.