Investment losses of 25% are not associated with government gilts.

This year, the price of a ‘safe’ 10-year UK government gilt has fallen by 25% and that of a 30-year gilt by 50%. The price of an index linked 15-year gilt has fallen by 60%.

Investment falls of these magnitudes are always associated with high-risk equities not government gilts. This crash in gilt prices has been coming for many years ever since the BoE started of quantitative easing (QE) which pushed down yields and as a result overvalued the gilt price. The BoE kept buying up bonds to place cash into the economy and this has continued up until recently when the BoE started selling off their balance sheet of bond assets.

We have enjoyed a 40-year bull market in cheap money, low inflation, and low interest rates. Governments around the world have cut rates and stimulated economies with borrowed money, we are witnessing the consequences.

The Bank of England is tasked with the control of inflation while also avoiding financial crisis. In September we saw these objectives being stretched and pulled in opposing directions.

With exceptionally high inflation of 10.1 % and expected to rise even further to around 12%, the UK requires significant monetary tightening. The BoE has been criticised for being so slow to act and not get ahead of rising inflation early enough and therefore, we face tougher medicine now.

Septembers failed mini-budget was seen as fuelling inflation with tax cuts, while the BoE were seeking to suppress inflation with interest rate cuts and quantitative tightening. The BoE response to support pension funds in need of margin call liquidity was to offer lender of last resort cover through purchasing gilts. The Bank had to suspend the selling of gilts in order to buy gilts for a period of two weeks. Anything longer would undermine monetary tightening and for this reason the BoE could only have supported the gilt price for a short emergency period. Long term 30-year gilts yields rose from 3.6% to 5% at the mini budget only to fall back to 3.85% on the BoE intervention. They are now standing at 3.78%.

Treasury and BoE policy makers want to minimise volatility but they do not want to minimise yields as this would be seen as yield curve control. The Treasury authorised the BoE to purchase up to £100m in the gilt market in order to create stability. In the end only a fraction was used as the threat was in its self, sufficient.

The last 15 years has seen us become used to near zero yields, however with the world now experiencing shortages in supply of gas, food, semiconductors, and labour, it is only to be expected that interest rates will have to move higher to establish the balance between supply and demand.
Higher inflation has necessitated central bank action and that higher yield levels are needed to be attractive to investors. A higher yield is paid for in the bond price and these have fallen heavily in response to rising yields. Once inflation is seen to have peaked, yields can stabilise along with prices so that the interest in bonds will improve.

The selloff in gilts was not because of gilts themselves but through the need of pension funds to liquidate assets in order to pay margin calls on their derivative investments.

Ironically, higher gilt yields are a positive for any fund with long term liabilities. With rising bond yields, the discount factors for liabilities goes up and current valuation of future liabilities goes down.

Over the longer-term UK corporate and government bonds look like a good buy as yield based returns are looking better than has been the case for over a decade. This year we have started a down turn in bond prices after nearly 40 years of rising prices. When the bull market for bonds started in the 1980’s the 10-year gilt yield was 16% it is now 3.46%. While yields have fallen then in proportion prices have risen. We are now seeing the reverse.

Equity markets are very influenced by bond markets and are not likely to rally until global bond markets stabilise. Bond markets are perhaps now reasonably priced and yields will only rise if interest rates and inflation push higher than expected. A key moment of change will come when US core inflation declines. At that point yields should stabilise.

US 10-year treasury yields hit 4.3% in October but are now 4.19%. This was aided by the US economy growing in Q3 by 2.6% as compared to market expectations of 2.4% and returning to growth after both Q1 and Q2 were negative. The Fed, as expected hiked by 0.75% in November but is now expected to hike by 0.5% in December and 0.5% in January before stabilising at 5%. The UK is expected to stabilise at 4.5%.

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