Bond bites: are we tempted by UK duration?
This is the first episode in our ‘Bond bites’ series. Each month will bring a new, easily digestible instalment. Catch up on all things fixed income in under three minutes.
This week, Lewis Aubrey-Johnson asks: is the recent underperformance of gilts enough to tempt the Henley Fixed Interest Team back into UK duration?
Today I’m going to talk about the reasons for the recent underperformance of gilts and discuss whether or not this recent move is enough to tempt us back into UK duration.
We’ve really seen an intensification of the underperformance of gilt markets in the last couple of months, and I think that is all to do with changes in the money markets.
Back in August, for example, the UK was pricing in just two rate hikes. One in April next year; the other in December ’23.
Now we have a rate hike not only priced in for November, but a further three priced in by next summer.
In pricing terms, we’ve gone from expecting a 40 basis point bank rate at the end of next year to a 1.2% rate. That’s a pretty big move in a relatively short space of time.
Why’s this happened? Well, a couple of reasons, I think. First of all, clearly there’s inflationary pressures building. The economy is recovering, we’re seeing supply-side pricing pressures everywhere, energy price inflation, and so on.
The headline rate is above 3%, and that’s a little bit higher than we’re seeing on the continent. However, inflationary pressures aren’t unique to the UK and, in fact, when we look at the US, the headline rate of inflation there is above 5%.
So why are we expecting rate hikes here, but much less so in the US? That really, I think, comes down to the different mandate and approach of the two central banks – the Fed and the Bank of England. In short, I think the Bank of England is much less willing to tolerate above average inflation than the US, and we’ve seen quite hawkish statements coming out of BoE members, MPC members, particularly Chairman Bailey.
Is this underperformance enough to tempt us in? Well, for the moment, no. We still think it’s essentially a bond unfriendly environment. These pricing pressures, I don’t think are going away any time soon. And the relative underperformance of gilts doesn’t really offer us, I think, any protection in the event of a more generalised government bond sell-off.
We remain cautious for now.
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