UK bond market chaos: how to stamp out volatility in the Gilt market

This week is turning out to be another wild ride for UK asset markets. UK bond yields continue to surge and are currently above their G7 peers, stocks are lower, and the market is waiting with bated breath for the latest US CPI report on Thursday. The focus in the UK so far this week is the Bank of England. The Governor said on Tuesday that its emergency Gilt buying scheme would come to an end on Friday. This caused a frenzy in the market and the financial press, and on Wednesday morning an article in the FT quoted unnamed sources from the BOE who said that the scheme could be prolonged to prevent more fire sales of pension fund assets. This was quickly dismissed by the Bank of England, who reiterated that the programme would end on Friday. Queue UK long end Gilt yields surging to levels that were last seen on 28th September when the BOE stepped in with their emergency scheme. This forced the BOE to step into the market to buy Gilts and bring down bond yields. No wonder the UK has a credibility problem, even the BOE is flip-flopping from one move to another.

An impossible job for the BOE

The lack of clarity of the BOE’s intentions seem to have compounded the problems with the government’s fiscal plans. While this is being unfair on the BOE, it would be far more helpful if the BOE stuck to one line. Andrew Bailey’s argument for why the emergency bond scheme must come to an end this week is true: the BOE’s focus needs to be on bringing down inflation, but by managing the fallout of the Kwarteng mini budget that caused a liquidity crisis for pension funds at the same time as they are raising interest rates then they are essentially fighting against themselves. This is not helpful for our central bank’s credibility, at a critical time when it needs to be respected by financial markets. The problem for the BOE is that it is trying to treat the symptoms of the UK’s economic problem, which it can’t resolve: the government’s fiscal ineptitude. As we have said in prior notes, the pound’s volatility has been super charged by politics since the Brexit vote, the same is now happening to the UK Gilt market. Thus, at this juncture we believe that there are only three ways that the UK bond market will stabilise:

1, The BOE extends its emergency Gilt buying programme. It intervened in UK bond markets on Wednesday after the 30-year Gilt yield surged above 5% and rose to nearly 5.1%. After the BOE stepped in on Wednesday afternoon, the 30-year yield fell to 4.8%. This is still 93 basis points above the 30-year US yield, and it is also 1 basis point above the Italian yield. 10-year Gilt yields fell by a similar magnitude after the BOE’s £4.4bn intervention. The BOE has only spent £12bn of the £65bn emergency fund, thus it is no wonder that pressure remains on the UK Gilt market. Why would the BOE make the fund so large if it had no intention of using it to buy bonds? Considering the BOE has told pension funds that time is running out to shore up their balance sheets, then they may need to seriously ramp up their purchases between now and Friday. We believe that the BOE will need to extend and formalise this programme, after all, it is meant to be used when there is an emergency in the bond market. With the amount of excess volatility in the UK bond market right now, there could be plenty more emergency situations in future. Added to this, the BOE has not helped itself, the market is in no mood to be taunted by a large bond-buying fund without it being used. Hence the smell of vigilantism when it comes to the current selling of UK gilts.

2, A change in government: This is the most likely endgame for the UK bond market volatility, in our view. We have mentioned that the pound’s excess volatility in the last 6 years is directly linked to economic policy uncertainty, this volatility has picked up substantially since the Chancellor’s mini budget on 23rd September. We would also extend this view, to say that economic policy uncertainty is also weighing on the bond market. Thus, the root cause of the current problem is economic policy uncertainty, so if that can be eradicated – by a change of government – then the problem could be solved.

3, The Fed/ BOE pivot: This doesn’t seem likely. Fed minutes from the September meeting made it sound like most Fed members would rather walk on hot coals than halt their rate hiking cycle and bring down inflation. Added to this, monthly producer price inflation in the US may have shown a moderation in the annual headline rate to 8.5% in September, however, monthly price gains in the PPI were 0.4%, which is still exceptionally high. Thursday’s CPI reading is also expected to deal a blow to those looking for a policy pivot from the US central bank, it is expected to show a monthly and annual growth in the core CPI rate. Expectations are rising that hot price growth in the US will fuel further rate increases, the CME Fedwatch tool is now predicting a near 85% chance of another 75bp rate hike from the Fed next month. Added to this, the BOE chief economist, Huw Pill, said on Thursday that there would be a big rate increase from the BOE next month. Considering 5-year Gilt yields are 4.45%, and UK interest rates are 2.25%, then there could be large rate increases coming down the line. The risk is that the BOE, the Fed et al will hike rates to such an extent that it provokes a recession next year. Once that happens, the Fed and the BOE will pivot. Thus, while some people fret about rate increases, it is worth remembering that every large rate increase we get this year is a step closer to a Fed pivot.

It is also worth noting that the FTSE 100 was the second worst performing blue chip stock index in the US and Europe today, ahead of Italy, and this may continue as the bond market crisis rattles investors in UK stocks. The pound had a stunning day on Wednesday and rose more than 1.16% and was the top performer in the G10. The prospect of higher interest rates along with the IMF’s view that Truss/ Kwarteng budget could boost growth, albeit with consequences, is obviously driving demand into the pound, although we do not think that this optimism will move across to the bond market. We would also point out, that the London Stock Exchange said that it would allow market makers to quote wider than usual spreads for UK Gilts until further notice. This is a very rare event, especially since if it is allowed it is usually only for one day, not indefinitely. We will be watching this to see if it helps to stabilise a beaten and battered Gilt market in the coming days.