Alex Rohner, fixed income strategist at J. Safra Sarasin Sustainable Asset Management, shares his insights on Gilt yields.
A combination of elevated rate expectations and term premiums accounts for the highest long-term Gilt yields in almost 30 years. The structural headwinds weighing on long-term Gilts are unlikely to reverse quickly. While few details about the new Prime Minister’s economic policy measures have been revealed, they will likely require some additional front-loaded funding, which should keep term premia elevated. Yet we do see relief from lower rate expectations. While these will primarily benefit short- to intermediate maturities, they will also take pressure off the long end.
30 year Gilt yields have surged
Long-term Gilts continue to trade close to the highest levels in almost 30 years. To get a sense of what is going on, we take a closer look at the evolution of the components that typically make up a long-term government bond yield: firstly, the component driven by expected BoE monetary policy and secondly, the component determined by the term premium for holding duration risk. The term premium compensates investors for unexpected inflation risks, central bank policy uncertainty, risks relating to debt sustainability or changes to structural supply- and demand dynamics. For our purposes, we define the term premium as the difference between the yield of a long-term government bond and the short-term market-implied OIS rate in 2 years, a proxy for the expected path for short-term rates.
Monetary policy is a driver for long-term yields
The expected path for short-term interest rates is a significant driver for long-term yields, particularly when rate expectations move sharply, as they did in 2022/2023. Throughout the 2010s, long-term Gilt yields exhibited a meaningful degree of correlation with moves in short-term rate expectations, although a – term premium – gap to short-rate expectations opened as policy rates were cut after the global financial crisis. Before that, long-term Gilt yields seemed to trade consistently at lower levels than indicated by short-term rate expectations, suggesting the existence of negative term premiums at that time.
Three factors contributed to low term premiums
Three important drivers were responsible for the low or even negative term premiums for long-term Gilts since the late 1990s: firstly, the BoE was granted operational independence over monetary policy in May 1997, which significantly reduced inflation risk premiums; secondly, the pension reforms in the late 1990s marked a large structural demand shift towards long-term Gilts, mainly at the expense of equities; thirdly, The BoE joined other central banks in providing additional monetary stimulus by actively buying Gilts – Quantitative Easing, 2008 to 2012 and 2020 to 2021 –, which kept term premiums artificially low.
Headwinds for long-term Gilts are more evident
After the pandemic, important drivers that had suppressed term premiums have reversed: firstly, the Bank of England started to undo QE in 2022, actively selling Gilts to the private sector, secondly, the shift from defined benefits to defined contributions in the UK pension industry, a process that had been ongoing since 2012, accelerated and meant fewer price-insensitive buyers for long-term Gilts and thirdly, large deficits due to expansionary fiscal policies and sharply higher interest rates have led to government debt sustainability concerns that the wavering labour government under Keir Starmer was unable to dispel. 2022 also marked the start of a fierce sell-off in the fixed income space as central banks embarked on one of the most aggressive interest rate hiking cycles. As a result, term premia are elevated, while, at the same time, interest rate expectations remain high due to inflationary pressures, a combination that has not happened since 1998.
The new government’s priorities will require additional funding
Enter Andy Burnham. The former Mayor of Greater Manchester will likely take over from the hapless Keir Starmer. While few details about Burnham’s economic policies have been revealed, they will likely involve firstly, the transfer of fiscal and policy powers to regional governments, secondly, more public ownership and tighter regulation of essential public services, thirdly, public investment in health care, social care and social housing, finally, public-private infrastructure and industrial partnerships, to name just a few. These measures are likely to require front-loaded additional funding.
Maintaining Gilt market confidence will be a balancing act
Although Burnham has said that he will operate within the current fiscal framework, he will likely insist on extra flexibility. Demanding greater flexibility for front-loaded expenditures, while maintaining the confidence of the gilt market, will be a difficult balancing act. The new government will need to make a convincing case that its policies boost long-term economic growth, while high profile economic advisors, such as Andrew Haldane, former chief economist at the Bank of England, will need to convince Gilt investors to be on board. And while Andy Burnham seems to be prepared to take bolder action than his predecessor, success is neither guaranteed, nor will it be quickly visible.
Expect some relief from lower BoE rate expectations
Consequently, term premia and volatility in long-term Gilts will likely remain elevated. That said, we see relief for Gilts from lower rate expectations. Markets are still pricing an overly tight monetary policy path over the next 12 months as an expected policy response to the risk of higher inflation expectations due to the energy price shock. BoE rate expectations and bond yields should ease as inflation concerns diminish. While this will primarily benefit short- to intermediate maturities, it will also take pressure off the long end.
