JP’s Journal: Higher and steeper

Bond markets stole the headlines last week. A year on from the Liability-Driven Investment crisis, 30-year UK yields are back to where they were in early October 2022, nudging 5%.

The Bank of England’s decision to hold rates at 5.25% gave a respite to short-end yields but this has not translated into rates on longer maturities. But before we get too parochial about this, it is worth noting that the steepening of yield curves is a global event.

Let’s look at how US treasury yields have moved over Q3. Two-year rates have risen from 4.9% to just above 5% whilst 10-year yields have shifted up by 75bps to 4.6%. But a bigger change has happened at the long end. Back at the end of June the 30-year US treasury yield was below 3.9%. At the end of last week, the rate was 4.7%, at levels consistently seen in the 2002-2007 period. In Germany, the picture is similar with 30-year bond yields closing above 3%.

A key question is whether these rates are the new normal – and that the period 2007-2021 is the aberration. Well, my view remains that the ultra-low yields and even negative yields are not sustainable and I do not expect a return to those conditions. What we are seeing is a rise in real yields – a theme that I touched on last week. How far this goes will depend on global growth and inflation. Supply factors also are weighing heavily at the moment and has been a factor in our caution on ultra-long-dated bond yields – particularly in the UK. And the rise in the oil price may be causing concern that inflation gets another boost.

I am sticking, however, to my view that 10-year yields look good value. Indeed, I can take heart from the latest inflation trends in the US where core measures are indicating a significant cooling in price pressures. The UK has not matched the scale of this disinflation but in my view a slowdown is on the way. This may seem strange when we saw another upward revision to UK growth – reflecting stronger output recorded in Q1. Surprisingly, it was an upgrade to business investment that moved growth higher. I do not think this will last. Overall, UK data showed that the savings rate has increased to just over 9%, despite the squeeze on disposable real incomes. This may be another indicator that strong wage growth is helping. But this only can be maintained if employers are willing or able to pay and I think we will see a change on that front. Looking at the latest data we can see that broad money growth turned negative for the first time. Some of this is due to quantitative tightening, or QT, by the Bank of England but tighter monetary policy is having its effect. And with the average quoted mortgage rate of around 5.7% I think we will see more weakness in housing activity.

On the global front the latest global trade figures showed signs of weakness although Chinese exports are on the rise, with particular growth in car sales. Indeed, Chinese growth rates are stabilising despite renewed problems in the real estate sector. This may ease the pressure on Germany and help their exports to China although the latest IFO Institute survey remained pretty downbeat. A slight upward move in expectation may be a sign of better times.

Friday saw the end of Q3 and from a bond holder’s perspective it was pretty mixed. Sterling investment grade debt recorded a positive return of 2.2% which has pushed the year to date (YTD) out-turn into positive territory. Not so for gilts, which recorded a -0.7% return in Q3 and -4.5% YTD. However, from a global perspective UK bond markets were relative winners. Total returns in US treasuries and German bunds were significantly more negative.

So, what explains the divergence in gilt and investment grade credit performance last quarter? There are two factors here. First, credit spreads narrowed by around 15 bps. Second, shifts in the shape of the yield curve were more beneficial for credit markets – having higher weightings in short and medium maturities and being less exposed to the yield curve steepening at longer maturities.

To end, it is ironic that the Conservative Party conference is in Manchester, given the mood music on the HS2 project extension, a project to deliver Britain’s new high-speed railway. From a policy perspective there seems to be some support for the resurrection of policies given the thumbs down by markets last October. Spending money you don’t have will not be well received – again.

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