Gilt yields look too high, given the economic outlook for the UK, but budget-related volatility is likely to maintain the status quo.
- Gilt yields appear to be pricing in significant – possibly excessive – amounts of bad news
- UK gilt prices continue to factor in three or four rate rises in the near term
- The UK is more fiscally prudent than many of its peers
The gilt market has been a tough place for investors since the start of the year. The average gilt fund has lost 1.5% since the start of the year, and index trackers focused on longer-dated gilts have been particularly vulnerable. Gilt yields appear to be pricing in significant – possibly excessive – amounts of bad news, but the budget may maintain volatility in the short-term.
Gilt yields have shown significant correlation with the oil price, with the UK economy seen as particularly vulnerable to rising prices. This has persisted even when that hasn’t proved to be the case. The UK economy has been relatively resilient to the oil price shock and inflationary pressures have not spread beyond energy prices into other areas.
Short-term UK gilt prices continue to factor in three or four rate rises. This looks unlikely. The Bank of England maintained rates at its latest meeting. While investors are expecting a rate rise in November, significant rate rises after that look unnecessary. The OECD said this week that the UK central bank could afford to keep interest rates at 3.75% until well into 2027 before starting to cut in the second half of next year.
So why are gilt yields still so high? They remain higher than the UK’s more indebted peers – France, the US, Japan or Canada – and high versus history. Miles Tym, a senior portfolio manager specialising in government bond and macro fixed income mandates at M&G, says inflationary pressures have not been the swing factor in rising bond yields. Instead, he points to the end of ultra-low interest rates, the reversal of central bank support, plus some fiscal concerns as well.
All of these factors may adjust over time, but they are not likely to shift in the near-term. The upcoming budget hangs over the gilt market like a 300lb gorilla. The briefing and counter-briefing has already started. There were leaks – denied by the Chancellor – that the Mansion Tax threshold might be lowered, plus the usual fretting around pensions taxation and a focus on capital gains tax. This week, the Chancellor has said he may allow a lower buffer to prevent further tax rises, conscious that Labour has raised taxes in the previous two budgets.
Against this backdrop, gilts are unlikely to adjust significantly in the short term. Any fall in the oil price could have an impact, while the Bank of England reversal of its quantitative tightening programme is already reducing pressure on longer-dated gilts. However, the UK will need to live with higher borrowing costs for the time being.
