Written by Jim Leaviss, CIO of public fixed income at M&G Investments.
It’s fair to say that the gilt market hated today’s mini-Budget. People are getting out their long-term history books and gilt charts to find example of worse one-day price moves.
Gilt yields have risen sharply in response to a combination of unfunded tax cuts (the cut to the highest rate of income tax, for example, was not expected) and the energy support measures (which were expected and are generally thought to be necessary). In what has already been a weak period for government bonds thanks to global inflation and central bank rate hikes, the UK has stood out as an underperformer.
This has been due to a combination of structurally higher inflation rates and a degree of political instability. As a result, the pound had already fallen to levels not seen since 1985, and it is falling again today (by around 2%). In the year to date it is down nearly 19% against the US$ – some of this move is about dollar strength, but on a trade weighted basis the pound is also down sharply this year, by about 8%.
At the beginning of the summer, when the Conservative Party leadership campaign began, 2 year gilt yields were about 1.7%. Yesterday they had risen to about 3.5%, but today they are another 40 bps higher at 3.91%. All maturities of gilts are selling off, with 10 year gilts 31 bps higher today at 3.8%.
Market based measures of inflation expectations in the UK have also risen today, with 5 year breakeven inflation (derived from index linked gilts prices and based on the UK’s RPI measure) up 20 bps today at 4.5%. Whilst the market is worried about the massive increase in government borrowing, the tax cuts for both households and corporates should reduce the severity of the expected recession (yesterday the Bank of England said we are likely already in a recession), and hence inflation may not fall by as much as anticipated.
Controversially, there was no OBR analysis of this ‘fiscal event’, but it looks to be the biggest tax cutting event by a government since Barber’s Budget of 1972, 50 years ago. This generated a short-lived ‘boom’ designed to return the Conservatives to power in a general election a couple of years later (but it is noteworthy that one of the big investment banks has not increased its growth forecast for the UK as a result of this fiscal splurge).
In practice the Barber Boom generated inflation and led to the government having to introduce emergency price controls and pay boards. And his party lost the 1974 election. The gilt market is struggling to digest the news that the DMO will need to borrow another £72.4 billion in this financial year, increasing borrowing to £234.1 billion. Most of this increase (£62.4 billion) will come through gilt issuance. It seems difficult to believe that the Bank of England will be able to unwind its QE gilt holdings (nearly £900 billion) as planned given the government’s ongoing borrowing requirements.
The rise in yields will already be feeding through into new fixed rate UK mortgage rates – and as tax cuts will disproportionally benefit the highest rate taxpayers (who have a low marginal propensity to consume) it is possible that those higher mortgage costs will have more economic impact than the ‘animal spirits’ unleashing that the government hopes for. The government also pins its hopes on a Laffer Curve argument that lower tax rates boost growth (‘the size of the pie’) by so much, that the tax take actually goes up. There’s not much evidence for this unfortunately. And whilst Reagan’s tax cuts are often quoted as the inspiration for Trussonomics, under his presidency the debt/GDP ratio in the US actually increased.
About 25-30% of the UK gilt market is held by overseas investors – the famous quote is that we ‘rely on the kindness of strangers’ to finance our budget deficits. Having suffered disproportional losses in the gilt market via both the underperformance of gilts and the weak currency, there might be some reassessment of the UK by these investors – although arguably its cheapness now might attract bargain hunters.
Global credit spreads have been weak over the summer and they are wider today too. The iTraxx crossover index, a CDS index of high yield names, is 26 wider today, at 645 bps. This is getting towards levels associated with recession.”