Technical factors dominate as gilts extend rally
Mark Dowding, partner & co-head of Investment Grade Debt at BlueBay Asset Management, gives his latest view on the markets.
Global markets were mostly quiet in the past week, with something of a summer lull with no significant data releases or new policy developments of note. Core fixed income yields rallied modestly with little new supply.
The UK led the rally as an uncovered bond buy back from the Bank of England (BoE) led to a strong bid for long-dated bonds. With global central banks set to buy back over $300bn of government bonds before the end of 2016, technicals continue to dominate in bond markets for the time being. In the UK this means 50 year UK yields, at 0.77%, are now only 10bp above their euro equivalent.
This looks particularly anomalous to us. Looking at the UK we believe inflation (which is already higher than in the eurozone) is set to rise materially as a result of rising import costs post-Brexit.
We also believe that expansionary fiscal policy and a central bank which will overlook the inflation target and focus on growth should also bring about a steeper UK yield curve over time. On top of this, we see a need for material political risk to be discounted with the threat of a UK break-up likely to come back on the table, as soon as the formal Brexit process commences.
Commensurate with this we continue to look for sterling to weaken with the current account deficit needing a materially weaker currency in order to come back towards balance. Yet the rally at the long end of the curve seems to have less to do with fundamental or valuation considerations at the current time and is very much being driven by technical factors (as we have seen in recent years in other markets).
In our view, there is scope to intervene in order to mitigate this relentless rally in long-dated UK assets. We believe that policy makers are aware that savers in pension funds are being forced into ultra-low yielding securities, which will inevitably post losses over the medium term in real terms. This is not a healthy situation.
Moreover, the rally in yields has seen UK pension fund deficits swell towards £1 trillion on some estimates, due to the obligation to discount future liabilities at this ultra-low level of long-dated rates.
In this way, a rally in yields makes pension deficits worse, which means companies need to divert cash into pension schemes that could go towards creating (or saving) jobs, or investment , just so this can be used to buy these long dated securities and push their prices ever higher.
In summary, this negative convexity event due to a policy failure with respect to pension fund accounting regulation is hurting savers, hurting the economy and costing jobs. Arguably the only individuals benefitting are those retirees who have been responsible for the Brexit vote in the first place.
We believe that an answer to this problem would be to set a floor for the minimum level that liabilities get discounted, at a level equivalent to the BoE inflation target. This would break this self-fulfilling loop where long-dated prices are pushed relentlessly higher. It could benefit the economy, benefit savers and help jobs.
Importantly though, we do believe that we are living in times when policy making is becoming more creative at a time when traditional policy is running out of room.
Also we believe policy makers are increasingly aware of the negative side-effects of their actions; as the BoE showed in seeking to immunise banks for any negative impacts stemming from its latest easing and so we do believe there is scope for intervention in this market, which makes a short stance at the long end of the UK swaps curve a compelling position to adopt in our view.