Is lift-off in UK bond yields a step closer?

06 September 2021

Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

You’ll find a short briefing below. To read the full article, please select the ‘full article’ tab.

  • Summary
    • The Bank of England has recently adopted a more hawkish tone, implying an earlier-than-expected hike in interest rates and a move towards reining in its stimulus measures
    • Any change in policy could result in an upward movement in UK government bond yields
    • Historically US yields and UK gilt yields have been closely correlated while since 2016 US yields started to yield more than UK counterparts. However, if higher UK inflation persists then the gap may narrow again
    • The expected shift in central bank policy may hit corporate bond performance – although “carry” returns might still be an efficient way to gain yield in this sector rather than taking on longer duration.
  • Full article

    A more hawkish Bank of England may imply higher UK rates. However, the prospect of much higher rates in the short term seems far from certain. That said, UK rates have scope to close the rate gap with US counterparts in the longer run, while corporate bonds offer an additional liquidity and credit premium.

    BOE takes a more “hawkish” tone

    The timing of when the Bank of England (BOE) starts lifting rates from their record low is a question on many investors’ minds. The central bank seemed to take a slightly more hawkish stance on the possibility of such rate hikes last month. But, will the stance be maintained at September’s BOE monetary policy meeting?

    In August, the BOE signalled the possibility of earlier than previously envisaged rate hikes. Governor Andrew Bailey expected that annual UK inflation would peak at around 4% before moderating again. This in turn would justify monetary normalisation sooner than expected. Bailey stated: “Should the economy evolve broadly in line with the central projections...some modest tightening of monetary policy over the forecast period is likely to be necessary.”

    Treading carefully

    In judging interest rate policy, governor Bailey had long placed much emphasis on the monetary support and the downside risks to the UK economy. July’s higher-than-expected inflation figure of 2.0% after 2.5% in June, on a year-by-year comparison, had to be acknowledged and the inflation prints are likely to provide the central bank with more confidence in respect of when and how to “normalise” rates.

    At the same time, Andrew Bailey sticks to his view of the transitory nature of recent inflation, in line with his counterparts Christine Lagarde at the European Central Bank (ECB) and Jerome Powell at the US Federal Reserve, and says that the central bank is not in a rush to lift rates. The ECB in 2011 demonstrated the dangers of a central bank prematurely hiking rates during a fragile recovery.

    Scope for rate hikes seems limited

    As a result of the BOE’s slightly more hawkish tone, the rate market pushed up by 15 basis points its expectations of a first rate hike by mid next year, based on forward-implied rates. That said, there seems no conviction for any hikes before 2024 thereafter.

    Even the central bank’s own inflation forecast would not justify rate hikes beyond 0.5% before 2024. After peaking at 4% in 2021 the central bank expects inflation to moderate to 2.1% in 2022 and fall back below its own 2% inflation target by 2023. Hardly a backdrop for rate normalisation.

    It seems too soon to tell whether the higher inflation seen in recent months is part of the transitory environment or a persistent trend. Like in the US (as mentioned in June’s Market Perspectives), the evolution of inflation in this cycle is likely to start with the base effects (higher rates due to the lower price levels seen a year ago at that stage of the pandemic) followed by pent-up demand and bottlenecks (as economies catch up with trend growth).

    While a more prolonged economic upswing may add to additional inflationary pressures, the state of the recovery is still too early and uncertainties around any pandemic-related setbacks remain prevalent. It seems more likely that the BOE will need to adjust the neutral rate of inflation, or the interest rate thought to be needed so the economy can operate at full employment while keeping inflation at its target rate, to compensate for this uncertainty.

    Opening the door for tapering

    The uncertainty around economic prospects and inflation is one of the main reasons why the BOE has lowered the threshold level from which the central bank is mandated to taper the asset-purchase programme to 0.5% from 1.5%.

    Rates of 1.5%, for now at least, seem out of reach and the central bank needed to make this adjustment if it ever wants to start normalising its balance sheet. Besides, BOE members like Michael Saunders and Dave Ramsden have been in favour of an earlier cut in asset purchases for some time now.

    Steepening unlikely

    If the BOE still keeps policy rates very low while giving itself more freedom to reduce the balance sheet, it may be argued that the rate curve will steepen from here. While higher volatility is a possibility, a substantially steeper curve seems unlikely in our view. Governor Bailey has emphasised that in the first phase of any asset-purchase tapering, the central bank would not sell any bonds but let them mature and not reinvest the proceeds received.

    UK bond yields: playing catch up with the US

    UK rates at the long end are likely to be impacted by the global backdrop as seen in the recent past. In addition, the correlation between the US 10-year yield and UK gilt yields has generally been quite high compared with other developed market rates in the past. The exception was 2016, when US rates surged on the back of the “Trump reflation policy”, or policies from the former president aimed at boosting US growth and risking lifting domestic inflation, while UK gilt yields were capped by Brexit uncertainties.

    The yield gap opened between US and UK 10-year bonds in 2016 that peaked at 1.6% in August 2018 and now stands at around 0.7% (see chart). US yields have been higher than UK equivalents for the longest period for over 30 years.

    Should elevated inflation persist in the UK it is likely that this gap would close significantly, if not disappear.

    Credit and liquidity premium

    Like in most regions, UK credit spreads seem to have reached their lows and in the case of high yield spreads have started to widen slightly. Less central bank accommodation in the future may result in more muted corporate bond performance. Still, carry returns seem to be an efficient way to gain yield as opposed to taking on longer duration.

    UK spreads today, as in the past, trade at a slight premium owing to the market being less liquid and smaller compared to US or European counterparts, which provides opportunities.


Market Perspectives September 2021

Our investment experts highlight our main investment themes, looking at the outlook for the global economy, why we have raised S&P 500 earnings forecasts, prospects for UK rates, private markets and what the nearing COP26 climate talks mean for investors.

Related articles

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This communication:

  • Has been prepared by Barclays Private Bank and is provided for information purposes only
  • Is not research nor a product of the Barclays Research department. Any views expressed in this communication may differ from those of the Barclays Research department
  • All opinions and estimates are given as of the date of this communication and are subject to change. Barclays Private Bank is not obliged to inform recipients of this communication of any change to such opinions or estimates
  • Is general in nature and does not take into account any specific investment objectives, financial situation or particular needs of any particular person
  • Does not constitute an offer, an invitation or a recommendation to enter into any product or service and does not constitute investment advice, solicitation to buy or sell securities and/or a personal recommendation.  Any entry into any product or service requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding documents
  • Is confidential and is for the benefit of the recipient. No part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays Private Bank
  • Has not been reviewed or approved by any regulatory authority.

Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.

Barclays is a full service bank.  In the normal course of offering products and services, Barclays may act in several capacities and simultaneously, giving rise to potential conflicts of interest which may impact the performance of the products.

Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.

Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation. Law or regulation in certain countries may restrict the manner of distribution of this communication and the availability of the products and services, and persons who come into possession of this publication are required to inform themselves of and observe such restrictions.

You have sole responsibility for the management of your tax and legal affairs including making any applicable filings and payments and complying with any applicable laws and regulations. We have not and will not provide you with tax or legal advice and recommend that you obtain independent tax and legal advice tailored to your individual circumstances.