Bond Market Investors Regain Confidence in Q4 as Central Banks Begin to Steady the Pace of Policy Normalisation

Main points

• The 10-year UK government bond (gilt) yield has been on an upwards trend over the year as a result of monetary policy tightening in response to the ongoing inflation shock. The gilt yield has stabilised in line with this trend following the volatility caused by the Truss government’s ‘mini-budget’.
• The term premium on UK gilt yields rose steeply in the aftermath September’s fiscal event but peaked this year on 3 November, when the Bank of England hiked its policy rate by 75 basis points and forecast a two-year long recession in the UK. It has been decreasing since, signalling renewed investor confidence in the path of interest rates. The recent upward path of gilt yields is driven by short-term interestrate expectations.
• Last week, policymakers at the Bank of England, Federal Reserve (Fed) and European Central Bank (ECB) all opted for a policy rate hike of 50 basis points, further cementing expectations of increasing short-term interest rates, though indicating a slowing in the pace of increases. All three central banks hinted at further interest rate rises over the coming months given that inflationary pressures remain persistent.
• Despite the ECB recently tightening monetary policy in concert with the Bank and the Fed, in contrast to those central bank sit is facing an increasingly fragmented environment, resulting both from high inflation and term premia dispersion among euro-area countries. In bond markets, Italy and Greece continue to decouple from trend, with our latest term premia estimates nearly 1 and 1.75 percentage points higher than the euro-area average, respectively. While this pales in comparison to post-Financial Crisis fragmentation, it still presents an important risk to financial stability and the transmission of monetary policy.

“UK 10-year gilt yields have stabilised on an upwardstrend, driven byincreasingshort-term interest rate expectations. Our term premium estimates for the fourth quarter of this year suggest that, after a month of turbulent market conditionscaused by the Truss government’s ‘mini-budget’,investors began to regain confidence in the path of short-term rates following the MPC’s meeting on 3 November. That said, policy normalisation represents a significant regime change; if rates are to riseby as muchand asquicklyas is currently implied by markets, there may well be further turbulence in the coming year.”

Paula Bejarano Carbo
Associate Economist, NIESR

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