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Global sovereign bonds have underperformed significantly since central banks embarked on aggressive monetary tightening in response to the post-Covid inflation surge.
UK gilts are amongst the worst performer in the G-10, dragged down by a sharp 5 per cent-plus rise in the Bank of England’s policy interest rate, larger than expected UK government borrowing, and negative sentiment overhang from last year’s gilt market rout after the mini-"Budget".
In this backdrop, we believe the BoE’s decision to step up reduction of its UK government bond holdings (ie quantitative tightening) risks pushing long-term borrowing rates even higher.
Consequently, most long-term investors in UK government bonds, ourselves included, remain very lightly positioned in long UK gilt (10 year plus) maturities, preferring overweights in short-dated (one to three year) bond investments instead.
Let’s revisit the basics. The BoE has been tightening monetary conditions to bring inflation back to its 2 per cent target.
The BoE could have opted for a slower and gentler balance sheet run-off profile. It is using two mechanisms: the conventional bank rate and QT. The latter is a reversal of quantitative easing, which entailed large scale purchases of own government bonds to inject market liquidity, lower long-term borrowing rates, re-stimulating credit demand, and helping raise inflation back to target.
At its September meeting, the BoE left the bank rate unchanged at 5.25 per cent in a knife-edge 5:4 vote split. Dissenters preferred another 0.25 per cent hike to 5.5 per cent.
On QT, the committee voted unanimously for a £20bn step up to £100bn over the next 12 months. This will be almost evenly split between £50.5bn in active market sales (a £5bn increase from last year) and £49.5bn in maturing gilts not being re-invested (ie passive QT).
The overall increase was at the top end of investor expectations, and targets a balance sheet size of £658bn by September 2024. Note that the target is set annually, and only revised under exceptional circumstances.
The BoE's communiqués are clear: first, it views the ‘new’ pace of balance sheet rundown as simply matching last year’s, which entailed £80bn reduction in UK gilt holdings and an almost complete unwind of its £20bn corporate bond portfolio.
Second, it has so far concluded that balance sheet reduction and asset sales have not disrupted proper functioning of financial markets and have had a much smaller and more benign impact than QE.
Above all, the bank desires a much smaller balance sheet to enable future deployment of effective QE programs – avoiding a Bank of Japan type liquidity trap.
We are much more cautious on the market impact of QT, especially on gilts and other UK fixed income investments.
Over time, the cumulative impact of QT should closely mirror the opposite of QE. Thus, where QE lowered term premia (the compensation investors require for investing in longer term versus a series of shorter-term government bonds) and consequently lowered long-term bond yields (raising bond prices), QT is having the reverse effect.
Over the past decade, the BoE has been the largest single market supporter of gilts through its structural QE buying programs. Current optics suggest a hastening retreat from the then-biggest sponsor of gilts.
This will likely reintroduce term premia into gilt market at a faster pace, pressuring UK long-term bond yields higher (and dragging bond prices lower).
It's negative impact is most pronounced in long gilt maturities; so-called ‘duration effect’ and should result in more pronounced curve steepening.
The BoE’s own internal models suggests a 0.4 per cent increase in term premium since QT started. It also admits difficulties in precise estimation of the impact of asset sales on Gilt yields. There is no historical precedence for QT, and only a year of empirical evidence.
Admittedly, rising UK term premia is not solely due to the BoE’s QT program.
Investors are also demanding additional premium for inflation protection (and UK’s inflation profile is sticky versus peers), while larger than expected government borrowing is weighing on demand, particularly from foreign investors.
In addition, last year’s market fallout from UK mini-"Budget" left a bitter taste amongst investors. Going into an election year, it remains unclear whether good fiscal policies will prevail, or the government may be tempted into spending giveaways.
The latter would be quite negative for UK gilts, hence sentiment remains on the edge.
Overall, UK fixed income markets have been quite volatile, liquidity is challenging, the outlook remains uncertain, and investor sentiment remains poor.
The BoE could have opted for a slower and gentler balance sheet run-off profile. We are surprised.
Prepare for bumpier times ahead.
Brian Marwingo is an investment manager within the multi-asset team at Barings
