Invesco: Operation gilt: what does the Bank of England's intervention mean for markets?

In a piece published earlier this week on Kwasi Kwarteng’s mini budget, our Director of Macro Research Ben Jones noted that UK fiscal and monetary policy were pulling in opposite directions.

This was cemented further on Wednesday when the Bank of England (BoE) stepped in to calm markets, pledging to buy £65 billion of government bonds.

What do the recent developments mean for markets? Our ETF, fixed income, multi asset and UK equity experts share their views.

Bank of England’s decision: impact on UK Fixed Income ETFs

The duration (interest rate risk) of the UK gilt market is the longest of the developed government bond markets, making its returns more sensitive to changes in yields. Given the magnitude of the rise in yields, the Bloomberg Sterling Gilt Index returned -9.1% in just three trading sessions to the close on Tuesday – a massive sell-off for a government bond market and taking the year-to-date return to -32.6% as yields had already risen significantly following a series of rate hikes.

Even the more conservative Bloomberg UK Gilt 1-5 Index, which focuses on short-dated gilts, fell by 2.6% in the same period, and is now down by 8.9% year-to-date. Following the Bank’s intervention, returns for broad and short gilts on Wednesday were +7.0% and +0.7% respectively. The broad gilt index bounced more strongly as the Bank of England (BoE) will buy gilts with maturities of more than 20 years.

But it’s not just the gilt market that has been affected by the moves. Sterling-denominated credit has too. The yield on the broad Bloomberg Sterling Corporate Bond Index had risen by 120bps over the three sessions to 6.9%. It only rebounded by 30bps to 6.6% on Wednesday though, lagging the rally in gilts.

While the initial impact has been exactly what the BoE would have wanted, the question now is whether it has done enough to stabilise markets over the longer term. The intervention period ends on 14 October, and it is planning to start selling gilts back to the market at the end of October. This is before the Chancellor (and the Office for Budget Responsibility) must provide further details on the medium-term borrowing plans in the budget on 23 November.

The impact of the announcements has also driven interest rate expectations to rise by around 100bps by the middle of next year, peaking at roughly 6%. On Tuesday, Huw Pill, the BoE Chief Economist, said that the government’s plans will be met with a significant monetary policy response. But markets will have to wait for their next interest rate decision and monetary policy report on 3 November, to see if sufficient tightening (raising of interest rates) has yet been priced.

A savage repricing

The UK corporate market is experiencing a savage repricing. For context, in 2008, the UK corporate bond market fell -9%. So far this year, the market is down a whopping -25%. By contrast, the FTSE 100 is down -4%. So much for the ‘low risk, low return’ moniker.¹

As has been well documented, the UK corporate bond market has been affected by higher government bond yields as well as wider corporate bond spreads. Much of this move was felt in corporate bond markets around the world in response to higher interest rates caused by inflation growth.
 

Sharp increases in gilt yields

In recent days we’ve seen further very sharp increases in gilt yields (with additional credit spread widening) that go way beyond movements in other bond markets. This is a result of a growing crisis of confidence in UK fiscal policy and the potential knock-on effects for UK interest rates. Indeed, UK 5-year gilt yields have risen 120bps since the middle of the month and now stand at their highest levels since 2008.²
 

The end of the low inflation, low interest rate era

In the very grand scheme of things, the general rise in yields we experienced until recently was an adjustment many had been waiting for. Over the past 20 years, bond markets have been shaped by three things:

• exceptionally low inflation and interest rates,
• a huge expansion of central bank balance sheets to keep inflation close to target,
• and a massive compression of all types of risk premia.

This era now seems to be over.

What will replace it remains to be seen. But, at the very least, we have an inflation problem that’ll need to be managed by significantly higher interest rates than we’ve been used to in recent years.
 

The challenges for the UK don’t end there

The UK economy is saddled with large twin deficits and relatively low growth. The government has also had to make another huge and unforeseen £140 billion financial commitment through energy bill subsidies for individuals and businesses. The subsidy is scheduled to last two years and, while its ultimate cost will depend on energy prices, this adds another element of uncertainty.

It was into this delicate backdrop that the new government chose to announce a further £45 billion package of unfunded tax cuts. These cuts weren’t accompanied by a forecast from the Office for Budget Responsibility, or by any medium-term plan to start bringing the public finances back into some discipline. The market reaction was swift and damning. Sterling weakened sharply and gilt yields rose precipitously.

This week, the adjustment threatened to turn into a rout due to forced selling from UK bond investors facing cash calls from derivatives positions linked to long dated bonds. News that the BoE was both delaying the start of its plan to sell gilts back into the market and in fact buying long dated gilts to restore stability sent yields sharply lower. Perhaps not quite the start that the new Chancellor had envisaged.

Gilts at the time of writing (Wednesday 28 September) are yielding a little more than 4%.³
 

A bumpy ride ahead

Given the scale of the market volatility, we don’t believe this is the time for making big statements about the near-term direction of the market. It could be a bumpy ride. The government is surely sensitive to the crisis in confidence and understands that it will need to convince the markets of a credible fiscal policy in November. It’s by no means a foregone conclusion though. The government has just committed to a sharp increase in borrowing resulting from both spending and tax cutting pledges.

All this damage to the markets has left yields quite elevated. The redemption yield of one of our corporate bond portfolios before fees is now 7%, and that comes from a broad spread of high quality and default-remote issuers. If one is prepared to take some balance sheet risk, we believe yields of 10% are achievable from UK household names.
 

Our views

While none of us know how events will unfold in the near-term, we are increasingly confident that the markets are beginning to look attractive over a two-to-three year time horizon. As active managers it’s right to be gradually adding high quality assets at these elevated yields.

Relief for pension fund collateral pools

The sell-off in long-end gilts put pension fund collateral pools under unprecedented pressure in recent days. The speed and scale of the move had pushed even the most rigorous collateral stress testing scenarios to the limits. This put pressure on pension funds to sell gilts (and equities) to realise cash for collateral calls.

The Bank of England’s (BoE) decision to delay intended gilt sales and announce temporary plans to buy long-dated gilts offers some relief for those facing severe strain on their collateral pools. It also reduces the risks to UK financial stability from the recent dysfunction of the gilt market.

But we don’t expect gilt purchases to entirely reverse the recent rise in yields. Quantitative tightening (QT) will not trigger the market to reassess rate expectations owing to the UK Chancellor's recently announced fiscal package.
 

Unintended consequences

There may be some unintended consequences. By delaying the start of active QT, front-end liquidity strains may intensify. This could present a problem for areas of the curve not supported by the latest action, which focuses on 20y+ conventional gilts. Recent extreme moves in the UK rates curve shape could get worse. The impact on public finances suggests the need for further rate hikes and may well provide further threats to Sterling in the near term, as the policy mix is somewhat incoherent.
 

What does the BoE’s decision mean for UK equities?

The current situation presents a positive environment for the relative performance of large cap UK equities versus overseas equities and small cap UK stocks. Indeed, it cannot be stressed strongly enough that the UK equity market is not the UK economy. Large cap UK stocks (e.g. FTSE 100 companies) generate around 75% of their earnings from overseas sources.

By virtue of the translation effect, weakness in sterling – especially relative to the US dollar and the euro – tends to support UK equity market earnings. As such, bad news for the UK economy and sterling can be good news for UK large cap equities. The current environment, value, yield, and commodity sector weight offered by UK stocks makes them attractive too, in our view.

Neville Pike, Product Director for Invesco’s UK Equities team adds: 

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It is our understanding that the intervention by the BoE was more about technicalities in the bond market than any attempt to influence equity or currency markets. While theoretically there might ultimately have been contagion from bonds to equities (potentially forced selling by pension funds of equities to meet collateral needs ) the read across to equity markets was and is likely to remain limited.

With so much uncertainty and so many risks currently at play, financial markets have been in turmoil and volatility is making for a bumpy investment ride. How can investors navigate uncertainty? Join our webinar on Wednesday 12 October at 2pm (BST) to find out.