Bonds are supposed to be boring. Investors buy them because they provide a predictable income stream. Pension funds buy them to hedge against their riskier bets. Prices and yields tend to be boring and predictable, but that's the point.
However, in recent months, the securities market, as UK government bonds are known, has turned on its head. Prices fluctuated wildly, moving at a speed not seen in recent years.
Last fall, when a small slice of the market threatened to blow up the pension industry, everyone blamed Liz Truss. The infamous "mini-budget" forever gone down in history before the ink dried, and for a while everything seemed normal again.
However, the peace brought by Jeremy Hunt proved to be only temporary.
Borrowing costs in the UK are now back to levels last seen during Truss' premiership. The benchmark 10-year bond yield rose almost a quarter of a percentage point last week to 4.4025%, not far from the high of 4.498% hit after markets were spooked by last September's financial report.
Yields on two-year government bonds, which are more sensitive to changes in interest rates, also rose.
By comparison, investors were demanding a yield of just 0.075% on the same bond less than three years ago.
What changed? The difference now lies in rampant inflation.
Back then, Rishi Sunak was trying to entice restaurant patrons "Eating out to help" How did the UK come out of lockdown? Prices stagnated and the economy was still in its worst recession since the Great Frost of 1709.
Today, inflation is 8.7%, which is much higher than in the rest of the G7 countries. Food prices are rising at a pace not seen since the 1970s, and even Bank of England Governor Andrew Bailey admits he has no idea when cash prices will start to fall.
Core inflation that deprives unstable food and energy spending are also proving to be more stubborn, as are wage increases in a still tight labor market.
2705 Core inflation continues to rise
“I think we're seeing a wage-price spiral, and to break that we need to make it harder for firms to raise prices and harder for workers to raise wages.” warns Martin Weale, a former rate-setter at the Bank.
The expectation of higher interest rates encourages investors to demand higher bond yields. After all, a higher bank rate leads to higher interest rates in the market, and investors should be fairly compensated for lending to the government.
But how much higher should interest rates be to keep prices down? ? Does he trust the Bank of England enough to do the job? And how many more bumpy roads lie ahead for the financial markets and the economy?
Answering these questions is critical not only for investors, but for the UK as a whole. Britain's higher borrowing costs will make it harder to pay off and we risk making us all poorer.
The situation has led many to wonder if we are not all paying for the inability of politicians to cope with inflation. .
This year, investors fell out of love with British bonds. Hunt's “boredom dividend” is not enough to shake Britain's so-called “moronic premium”, a term used in post-mini-budget markets.
Whereas the blame was placed at the feet of Truss and its Chancellor Kwasi Kwarteng in September, many now put the goon hat on the old lady of Threadneedle Street.
Imogen Bahra, Head of UK Betting Strategy at NatWest says overseas buyers and pension funds that used to look for gilts are now wondering if the UK offers value for money.
2705 who buys UK debt
After all, bond yields are usually fixed, making them a riskier bet when prices rise.
“Those natural buyers of gilts were noticeably absent this year.” Bahra says. “We don't expect them to return until they have more confidence that inflation is on a convincing downward trajectory. Investors want to have more confidence in the movement of interest rates, or at least more confidence that we are close enough or at the peak of the bank rate. And both of those things were pushed into the future with last week's inflation data.
She believes that the cost of borrowing will continue to rise. Bahra and her team already believed that the yield on 10-year securities this year would exceed the consensus level of 4.3%. Once they pass that threshold, they expect a return of 4.6 percent by the end of this year.
This is because the UK Debt Management Office, which functions as the Treasury Department of the Treasury, has been tasked with selling nearly £240bn of debt this year. Outside of the pandemic, this is the highest ever.
Supply oversupply naturally pushes prices down, with yields moving inversely with price.
Add to that the fact that the Bank of England, which was one of the largest buyers of securities in the last 15 years, recently became their seller.
After spending hundreds of billions of dollars buying up public debt in the post-crisis era, now trying to get rid of it.
Even British buyers are keeping aloof. General Investment Management (LGIM), which manages more than £1 trillion in assets, is shunning the UK for the US, especially when it comes to long-term debt.
As traditional buyers shun government debt, retail trade investors are entering the gap. The head of brokerage firm AJ Bell said this week that buying volumes have soared.
But this group doesn't have the financial firepower to counter investors who are retreating.
“I wouldn't be surprised if I see this [4.6% forecast] being exceeded in this environment.” says Bahra.
2705 — the cost of borrowing in the age of the mortgage crisis
Rise in government borrowing is not just an abstract concept: it has real-world implications.
Banks use securities returns and expectations future interest. rates to the price of the mortgage. As a result, economists expect prices to rise rapidly.
A jump in interest rates and yield expectations this week has sent swap rates — the benchmark for lenders' own borrowing costs — to their highest levels since October.
If swap rates stay this high, the burden will be passed directly to borrowers, says Andrew Wishart, senior real estate economist at Capital Economics.
The average five-year fixed-rate mortgage for a buyer with a 25% deposit was 4.2% in April, but “changes in market interest rates suggest it will rise again to around 5%,” says Wishart.
For a buyer taking on a typical £200,000 loan, a 0.8 percentage point increase in mortgage rates would cost an additional £1,600 per annum in interest. Over a five-year period, this means an additional £8,000 in interest.
Lenders such as Nationwide have already begun raising their rates. Brokers expect wide-ranging price increases to show up almost immediately.
This jump in mortgage prices will kill off new growth in the housing market, Wishart says.
Capital Economics expects home prices to fall by 12% from peak to minimum. They have already fallen by 4%, which means that most of the damage is yet to be done.
2904 house price drops
“It will just be a matter of time before we see this spread across the spectrum. It looks like we're heading into a more volatile period again,” says David Hollingworth of mortgage brokers L&C.
“We've already seen mortgage rates rise a bit. It will only speed it up. The pace of change is already gathering momentum.”
As worries spread, brokers are already drawing comparisons to the fall market turmoil.
“There are similarities to the fall from last year’s mini-budget,” says Nick Mendez of mortgage brokers John Charcol.
Then interest rate expectations, securities yields, and swap rates rose so rapidly that banks rolled mortgage deals en masse and then raised prices at the fastest rate ever.
Lenders start pulling deals and raising prices, though so far on a much smaller scale.
A couple of hundred mortgage deals have disappeared this week. There were thousands in the fall.
Homeowners shouldn't expect mortgage rates to drop below 3% over the next three years, Mendez says.
The increase will be a blow to buyers. . The most vulnerable group, however, will be existing homeowners.
The average mortgage holder with a typical £200,000 loan will have to pay an additional £2,000 a year in interest if the bank rate rises to 5.5%, at Pantheon Macroeconomics.
This average includes homeowners who are still protected by flat rate deals. For those who remortgage, the jumps will be much more significant.
Mortgage Cost Calculator
Mortgage holders will see their monthly payments rise to 30 percent of their income from about 20 percent in the last few decades, the chief warned this week, Barclays CEO.
K.S. Venkatakrishnan, known as Venkat, said the sharp rise in interest rates would lead to a “huge income shock”; by the end of next year.
Bailey warned that only a third of the effect of the interest rate hike has been felt in the housing market so far.
While the number of properties subject to foreclosure is still historically small, many struggling homeowners never show up in those numbers . Often families sell long before their lenders intervene, and it is clear that many households are already struggling as they have to adjust to the burden of higher mortgage bills.
According to TIC's Paran Singh
Finance, there has been a 50% increase in inquiries from homeowners with mortgage debt over the past year.
>”If interest rates rise even further, I expect there will be more than at least 25 percent growth,” he says.
How bad will the pain be? The question remains how high interest rates should be for politicians at the Bank of England to curb inflation. The Monetary Policy Committee (MPC), responsible for setting them, has already raised rates dozens of times from 0.1% in December 2021 to 4.5% today.
Now investors believe that by the end they will reach 5.5% this year.
However, just over a month ago, markets predicted that the tightening cycle would be over by now.
The upsurge was driven by inflation, which continues to bring nasty surprises.
р><р>Month after month it was higher than expected by City and Bank of England economists.
This failure undermined confidence in the Bank.
Officials expected double-digit inflation to end in February. When that didn't happen, politicians remained steadfast in their belief that price increases would quickly cool off.
When inflation remained in double digits in March, economists began to get nervous. The last straw was persistently high inflation in April, despite the fact that the general rate fell to the lowest level in a year.
The inflation surprise forced half the city to change its interest rate forecasts, with most forecasters now predicting rates of 5% or higher.
2705 post-budget easing
"Inflation readings were poor" says Willem Buiter, co-founder of MPC. He believes the Bank has been playing catch up for a while. "In order to solve the problem of inflation, UK discount rates must be increased significantly and quickly"
Buiter believes politicians should raise rates by half a percentage point at their next meeting in June. “I can see the Bank rate peaking at least 6%.”
Wheel, who was part of the MPC between 2010 and 2016, suggests that the Bank blindly believes that inflation is & #34; heavily influenced by business' expectations" naive at best. Trying to bring down inflation by driving business expectations is foolhardy.
"[Former bank manager] Mervyn King called it King Canute's theory of inflation" he says.
Mervyn King said that central banks can't expect inflation to stay low just because they say it will. Photo: Jeff Pugh
Part of the UK& #39;the problem is that there are more collective bargaining here than in the US. Doctors, railroad workers and teachers are threatening another strike if their wage demands are not met.
Raghuram Rajan, former chief economist at the International Monetary Fund, says: “Perhaps the combination of low real wage growth in recent years and more union activity in the UK understandably makes workers more frustrated with inflation than in the United States. . States are more willing to insist on their demands.
"This, in turn, can make inflation more stable, even under the same conditions."
Wil is known for his word choice, hence his decision to describe the current situation as a “wage-price spiral”; deserves attention.
“My personal opinion is that the decline in inflation will be slow as long as the labor market remains as tight,” he adds.
Jeremy Hunt suggested that the struggle inflation is the government's top priority, and the chancellor has signaled he is willing to tolerate a recession driven by higher rates if it keeps prices down.
The economics professor is more optimistic about the risks posed by higher interest rates to the economy.
“I don't think a recession is necessary to break the wage/price spiral,” he says. "For example, we could again find an increase in the supply of labor if people who fell out of the labor market came back"
However, it recognizes: " Perhaps this is the most likely way to reduce wage growth. With productivity growth very weak, almost any reduction in demand could lead to a recession. I don't think the BoE can break the spiral by simply saying it's aiming for 2% inflation"
The higher interest rates, the more painful it will be for the economy, says Buiter.< /p>
"Is it possible to reduce inflation to the target level within two years without a recession? Everything is possible, but not everything is probable" He says. “I'm afraid painless or flawless disinflation is unlikely to be on the British menu.”
Beiter expects additional policy action from the Bank of England, which is a mild recession in the UK that began at the end of this year"
While this is a grim forecast, it is seen as a necessary evil.
Michael Saunders , who left the MPC last year, says: “We have to break [inflation] because the longer it goes on, the deeper it takes root and the more expensive it is to get back to the inflation target. Waiting comes at a price."
UK Inflation, 2605
This is the new reality that investors are reacting to this week, causing the gold market to go wild.
Fortunately, pension funds are in a better position than last October. The surge in borrowing costs after the mini-budget has left many funds that used commitment-led investment (LDI) strategies struggling to meet the massive cash demands that fueled the fall riots.
Foundations have learned their lesson. : many have accumulated a cash cushion, which means that they are better prepared for new market chaos.
Bahra says: “Oddly enough, we hear that now they are almost double what they were last year. Thus, they are better able to withstand such high yields. And even if we get to these high yield levels, compared to last year it was a relatively small step. Therefore, I am not worried that this will lead to a repeat of the events of last fall.” However, Rajan, now a professor at Booth University in Chicago, warns that the risk of another market crash remains significant.
"Until inflation is firmly under control, it's probably premature to say we're seeing volatility for the last time" he says.
'It will be painful'
The chancellor was quick to say that a recession is a price worth paying to quell inflation.
"If we want to prosper, grow the economy, reduce the risk of a recession, we must support the Bank of England in the difficult decisions that it makes. he said.
The bank's actions have direct implications for Hunt, as he is due to issue a statement in the fall against a deteriorating economic backdrop that could force him to raise his tax burden further.
Ruth Gregory of Capital. The economist, who used to work for the Office of Fiscal Responsibility (OBR), says preliminary calculations show that a one percentage point increase in government securities yields increases the government's debt service spending by £8.9bn for 2027-28.< /p>
Every percentage point increase in short interest rates increases interest costs on debt by £7.9bn.
Market movements this week “if they continue, we can expect by 2027 £8 to £9 billion will be added to the interest on the public debt.” she says.
This would instantly wipe out the chancellor's already tiny £6.5bn reserve needed to meet his fiscal rule and reduce debt in five years.
1603 Reserve projections against budget target
It will have one more year to play with as economic and fiscal forecasts are pushed forward another 12 months. Stronger short-term growth could help offset the impact of higher interest rates. Whether that comes to fruition will be the deciding factor in whether the chancellor can get the pre-election tax cuts through as he would like.
Bahra says there is still time for markets to get back to Hunt' and still believes that in the end politics will take over the economy.
"We are approaching an election year. And so I think any reserve that the government has financially will just be recycled into campaign gifts in the months [before the vote]."
However, the gifts will eventually do little to hide the difficult path ahead. As long as inflation remains above the Bank's 2% target, the country is destined to bear the brunt of the higher rates.
Saunders, who is now a senior adviser at Oxford Economics, believes inflation to 2% will not return. be difficult, although it comes at a cost.
"We can make it happen. But it will hurt. Painful for the economy, painful for households and painful for business"