What do Developments in the UK Bond Market Mean?
The UK gilt market has shown exceptional volatility in the last few weeks as a consequence of domestic political and economic developments. In today’s Monday Interview, our research manager for global macroeconomics, Dr. Corrado Macchiarelli, speaks to data analyst Paula Bejarano Carbo about what we can infer from UK and global movements in bond yields.
We have entered a global tightening cycle, with many central banks – including the Bank of England – tilting towards more aggressive policy rate hikes as the result of a much more persistent inflation shock than previously thought. How are bond yields reacting, and to which extent are those movements reflective of investors’ confidence in the current and future monetary policy stance?
In general, the high-inflation environment has led to an upwards trend in 10-year government bond yields. To understand why this might be and what it could signal about investors, NIESR’s term premium tracker decomposes bond yields into two components: expectations of the future path of short-term bond yields and a term premium. Analysing these in parts can help us form a story about how financial markets are reacting to current changes in monetary policy.
Our latest tracker shows that short-term interest rate expectations have been driving the post-pandemic upwards trend in 10-year government bond yields for a number of OECD countries, including the UK. This is not surprising given that high inflation, caused both by supply chain disruptions and the war in Ukraine, has led many central banks to raise their short-term interest rates in an effort to dampen any demand-side inflationary pressure and regain control of price stability. Not only have central banks been tightening their policy rates, but they’ve been signalling future rate hikes in the near-term horizon. Last month’s BoE decision, for instance, was for a seventh consecutive hike (by 50 basis points), bringing interest rates to 2.25%, and noted that “the MPC will take the actions necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit”. It is no wonder that investors see the path of short-term interest rates continuing on an upwards trend, in turn driving an increase in long-term government bond yields. Historically, these market-implied interest rate expectation levels aren’t remarkable, particularly when compared to the levels observed during the mid-1970s; nonetheless, they suggest that the low-rate environment that markets have adjusted to in the aftermath of the Global Financial Crisis may be behind us for the time being.
We can think of term premia, our second component, as the compensation that investors demand in return for bearing the risk that short-term bond yields will not evolve as expected. Our decomposition suggests that changes in investor confidence in monetary policy are not driving yield increases in general. Investors remain broadly confident in the monetary policy stance, even if this confidence has deteriorated slightly recently. Our reading is that, given the inflationary environment and recent action by major central banks, any uncertainty implied by term premia will likely reflect a change in confidence in the pace of tightening, rather than the tightening itself.
An interesting part of the decomposition is that it allows us to evaluate the extent to which the UK term premium reacts to fundamentals (“news”) as opposed to market speculation (“noise”). How does the UK term premium behave in relation to other real-time estimates the Institute produces, such as the GDP or inflation tracker, or measures of uncertainty more generally?
Generally, UK term premia are countercyclical – they rise during recessions and fall during recoveries – and are positively correlated to losses of confidence, including those resulting from volatility as well as uncertainty about future inflation. Historically, term premia estimates and estimates of real-time macroeconomic indicators (e.g. GDP) are negatively correlated, while they are positively correlated with measures of uncertainty such as the VIX volatility index. These correlations could inform our understanding of the drivers of risk premia reactions.
However, the behaviour of government bond premia changed during the pandemic: despite the severe recession alongside increased volatility and uncertainty, the term premium on 10-year bonds did not move much. This development is generally attributed to central bank asset purchase programmes, which crowded investors’ demand out of the sovereign bond market while signalling a commitment to low rates.
In this sense, the current UK term premium does not reflect the broader economic outlook entirely. Under our present low-growth-high-inflation environment and the ongoing war in Ukraine, we would expect to see elevated term premia. Instead, the term premium on long-term government bonds has moved very little. As a result, while our interpretation of UK term premia has not changed, our understanding of their drivers has deteriorated. With the Bank of England’s quantitative tightening (QT) programme set to begin later this month (after a delay caused by the fiscal event) it will be interesting to see if we will witness term premia revert to ‘signalling’ uncertainty as they used to.
UK bond yields rose dramatically on the 23rd and 24th September in response to the fiscal event on the 23rd; they subsequently fell back after the Bank of England announcement to start targeted gilt purchases on the 28th. How much of these movements reflect risk premia vis-à-vis the higher future interest rates resulting from the inflationary impact of the tax cuts in the new fiscal budget?
As discussed in September’s term premium tracker, UK long-term government bond yields have been on an upwards trend in the post-pandemic period. This has been driven by an increase in short-term interest rate expectations as a result of the inflationary outlook. The associated term premium has been exceptionally low for over a year – it is safe to say that UK investors have been feeling relatively certain about the monetary policy stance.
On the fifth of September the term premium on UK 10-year gilts hit a post-pandemic low. It has been on an upwards trend since then, broadly corresponding to the start of the new Conservative Party’s leadership, sitting currently at 50 basis points above that series low. In the same period, the slope of the path of short-term interest rate expectations has steepened. As we argued last month, both trends suggest that developments in the UK political landscape both introduced market uncertainty that was previously absent this year and raised bond yields in a potentially speculative way.
In the aftermath of the fiscal event, further increases to the 10-year gilt yield can be attributed to raised short-term interest rate expectations resulting from the medium-term inflationary consequences of the mini-budget and the depreciation of sterling. Surprisingly, while intra-day gilt volatility has been exceptional, we do not observe significant volatility in the term premium as a result of this event alone. However, while inflation expectations seem to have been somewhat quelled by the Bank of England’s announcement of an outright intervention in the gilts market on September 28th, the UK term premium continued its upwards trend. Whether this increasing term premium is a temporary result of market adjustment or symptomatic of general (and indeed, global) heightened uncertainty and plummeting confidence will become clearer over the coming months; the pace and extent to which the Bank of England will decide to carry on with its policy of balance sheet reduction will certainly have a large impact in this respect.
Some of the developments in term premia might be ascribed to international financial movements. Do we observe any co-movements in risk premia across countries? For instance, the war in Ukraine represents a massive asymmetric shock to Europe. How are risk premia behaving in Europe and do we see any divergence across Euro Area countries?
Broadly speaking, we do observe co-movements in term premia across countries given financial markets’ global integration. These co-movements can be thought of as international spillovers from distinct channels, including risk and monetary policy developments.
The war in Ukraine has heightened general uncertainty and this is reflected in rising term premia for some Euro Area countries that we track. The extent to which intra-European differences in risk premia are a product of asymmetric effects of the war in Ukraine, however, is unclear. For instance, both Finland and the Netherland’s historically low term premia have seen a 150 basis point rise since the start of this year. Given that the Netherlands is both more geographically distanced from Russia and more energy independent than Finland, it’s hard to say whether markets are strongly reacting to these countries’ distinct exposures to the war. Moreover, we can see that Italy and Greece – two countries that have had historically elevated term premia due to structural factors and high debt – have experienced term premia increases of over 200 basis points, decoupling in trend from the rest of Europe. In the case of Italy, it can be speculated that markets are reacting more strongly to domestic political developments than other fundamentals, given the recent national election’s outcome. This has prompted the ECB to launch a somewhat controversial new anti-fragmentation tool, the Transmission Protection Mechanism, in conjunction with its interest rate tightening, to calm the threat of another liquidity crisis.