What were the main causes?
We don't see this as a UK centric episode of volatility, more a global fixed income phenomenon. The spread of Gilts over Bunds has risen, but the spread between Gilts and US Treasuries has remained more stable with only marginal underperformance in UK yields. This is partly a twin deficit linked problem; the UK being a small open economy with sizable fiscal and current account deficits makes it relatively vulnerable to a global shift higher in real yields, i.e. UK yields have a higher beta to US led yield moves. We do not view this as a Truss 2.0 mini-budget situation, rather a ‘Reeves 1.0'.
The factors that explain this global move higher in yields are threefold in our eyes:
- A more hawkish shift in monetary policy led by the US and a strong USD with persistent inflation being a key factor, in the UK this inflation persistence is driven by wages and elevated energy prices.
- Rising global term premia due to a pipeline of higher issuance for governments globally, a product of higher fiscal deficits in many countries.
- Market technical factors of positioning and ownership of Gilts: domestic pension and insurance funds only account for around 20% of ownership, historically being closer to 75%. This leaves the Gilt market more at the mercy of foreign demand and fast money flows.
The risk for Gilts from here is that if the recent weakness and current market expectations for approximately three cuts from the BoE in 2025 persist, then Reeves' Budget headroom against the government's fiscal rules will be wiped out. This would intensify concerns about debt sustainability and lead to an inevitable tightening of financial conditions. This would weigh on growth, leading to higher interest rates and a weaker fiscal doom loop of higher rates, more borrowing and lower growth. In short, we expect volatility to be higher in Gilts, and as such an active and nimble approach to duration positioning going forward will be key.
Source: Fidelity International, Bloomberg, 24th January 2025. Tickers used: USSG10YR, GUKG10, GTDEM10YR.
How do we quantify these effects?
Higher bond yields will increase borrowing costs for the UK government. Based on Office for Budgetary Responsibility (OBR) calculations, a 1% rise in long-term yields raises debt servicing costs by around £10bn per year. The modest headroom of the last Budget will be wiped out with yields at current levels. This would also impact fixed rate mortgages and floating rate bank debt, with estimates suggesting that a sustained 50bps rise in bank rates would shave around 0.5% off business investment and affect consumer spending and housebuilding. Net effects on GDP would be around -0.25%.
What do we view as potential policy responses and their impacts?
On the Government side, fiscal headroom needs to increase with commitment to meet fiscal rules and achieve sound public finances to provide comfort. The pathways we see to meet this:
- Reduced public spending and further cost efficiencies should benefit Gilts.
- Fiscal rule adjustments undermining credibility and likely hurting Gilts.
- Tax rises despite commitments to the contrary would undermine credibility but be good for Gilts.
From the Bank of England there are also several paths:
- Bond market intervention (quantitative easing). We view this as unlikely as there has been no forced Liability Driven Investing (LDI) selling as cash and collateral buffers are higher than during the 2022 Truss mini-budget.
- Postponement or reduction in quantitative tightening. The scale of the BoE's Asset Purchase Facility (APF) sales are smaller compared to issuance so this would have a limited impact other than signalling to the market.
- The Monetary Policy Committee (MPC) may need to cut more than currently implied as the tighter financial conditions will negatively impact growth and inflation. This should be good for gilts versus current levels.
- On the more contrarian side, the BoE could persist with a hawkish policy to tame inflation and control longer dated yields. This would be a bearish scenario for Gilts.
To draw these threads together:
We do not see this as a repeat of the 2022 Truss budget Gilt sell-off, but risks still persist. A lack of structural demand for Gilts and significant additional Gilt issuance, particularly at the long end of the curve, will likely weigh on Gilts this year. Government spending will likely have to be reduced given higher interest rates. Tightening financial conditions means the BoE may have to cut rates further than market pricing suggests.
How are we positioned against this backdrop?
Given our inclination towards viewing some combination of Government spending reduction and BoE action in the form of further rate cuts as necessary, we are long UK duration here, having tactically added into the recent sell-off given underperformance on a cross-market basis. We also believe the Gilt curve will continue to steepen from here, and as such prefer to have a steepening bias to our UK duration positioning.
IMPORTANT INFORMATION
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity's range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM: 8,792
