Markets Weekly podcast – 17 October 2022
17 October 2022
What could uncertainty in the UK bond market mean for pension funds? Michel Vernier, our Head of Fixed Income Strategy, discusses the potential implications of the Bank of England’s recent emergency gilt-buying strategy. While host and Market Strategist Henk Potts explores the IMF’s downgrade of its global growth forecast for 2023, the impact of political uncertainty on UK assets, and persistently high inflation in the US.
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Henk Potts (HP): Hello. It’s Monday, 17th October and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week, I’ll be joined by guests to discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the turmoil in UK bond markets, and finally I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
Dysfunctional gilt market, another disagreeably sticky US inflation report, and an aggressive global growth downgrade from the IMF created a volatile backdrop for investors last week. US stocks maintained their downward trajectory. The S&P 500 was down 1.6% over the course of the week. The index is now down 25% year to date.
In Europe, a slightly better performance. In fact, the STOXX 600 was flat over the course of the trading week. In bond markets, the US 10-year Treasury yield briefly rose above 4% on Friday, hitting its highest intraday yield since October 2008. Yields have now registered 11 straight weeks of gains.
It was a turbulent week for UK assets and policymakers, as concerns over the financial stability returned. Gilt yields surged higher after Bank of England Governor Bailey remained adamant that its emergency-support package would be withdrawn on Friday.
To remind you, the Bank of England introduced a £65 billion programme to buy government bonds in an effort to reduce pressure on liability-driven investment managers, given the sell-off in gilts following the mini budget on 23rd September. Then, on Tuesday, they expanded the scope of the bond-buying programme by adding inflation-linked debt to its purchases, after saying dysfunction in this market and the prospect of self-reinforcing fire-sale dynamics posed a material risk to UK financial stability.
The impact of all that? Well, 30-year gilt yields briefly rose above 5% on Wednesday. The gap between 10-year British and German bond yields surged above 220 basis points, that’s close to a three-decade high. We think, for investors, it’s certainly a confusing framework, as policy tensions continue to play out between both the government and the central bank. It also appears the Bank of England is caught between its price-stability and financial-stability mandate.
Towards the end of the week, bond yields eased back and sterling recovered, after the Prime Minister tried to placate markets by sacking the Chancellor and scrapping the planned freeze on corporation tax.
In terms of market tension, we think it will remain focused on political developments. Apparently, the new Chancellor will make a meaningful fiscal statement on Monday, at 11am, and the publishing of the fiscal plan and the OBR analysis is still set for 31st October. The government will be hoping this will be a turning point in terms of its perceived credibility gap, but as we know, the bar is certainly set high.
In the US, hopes that September’s inflation report would confirm that price pressures are indeed moderating at pace, were blown away after the CPI printed at a higher-than-expected 8.2%. That compared to our forecast of 8%. The report also highlighted that price pressures were more broad-based, including increases in shelter, food, and medical, adding to fears that inflation is becoming embedded.
Perhaps of more of a concern to policymakers, is the acceleration in the core reading, which excludes more volatile components such as food and energy. Core CPI rose to a 40-year high, 6.6%, up from 6.3% in August.
So, when we take the stronger-than-expected inflationary print, we couple that with the solid jobs report, which, to remind you, showed unemployment in September unexpectedly fell to a five-decade low of 3.5% and was accompanied by a firm increase in average hourly earnings, suggests the Federal Reserve will have to deliver a more aggressive finish to its hiking cycle.
In terms of the rate outlook, we keep the forecast for 75 basis points in November. We think that will be followed up by a further 75 basis point increase in December, then we look for one more 50 basis point hike coming through in February next year. That will put the terminal rate at 5% to 5.25% at the beginning of 2023.
The International Monetary Fund (IMF) sees the global economy growing at 3.2% during the course of this year. That’s in line with their July forecast, with a combination of the cost-of-living crisis, tightening financial conditions, the war in Ukraine, the ongoing disruption from the COVID pandemic has resulted in a broad-based and sharper-than-expected slowdown, the highest inflation in decades.
The Fund has downgraded its global growth forecast to 2.7% for next year. Outside of the pandemic, that would be the weakest performance since the financial crisis in 2009. By region, their forecast is that the US economy will grow at 1%. The sharpest downgrade was for the euro area that grows just half of 1%. UK growth is expected to come in around about three-tenths of 1%.
On the positive side, they expect growth in China to recover to 4.4%, and India will be the fastest growing major economy, at 6.1%, in 2023.
The recent global downgrade from the IMF is actually more optimistic than our current projections. We continue to maintain the view that advanced economies are likely to experience a mild and short-lived recession during the course of next year, with a contraction of three-tenths of 1% pencilled in.
We think global growth will remain positive but weak at 2.2%, helped, as we said, by that recovery in China and strong performance coming through from India.
While we have become more pessimistic on global growth prospects, we should acknowledge that labour markets remain robust, consumer and corporate balance sheets still look healthy, excess savings are still cushioning demand, the service sector continues to have plenty of room to recover.
I think we would also argue that price pressures look set to peak in the coming months and the end of the hiking cycle is within sight, albeit it at a higher level, which should take some of the intensity out of the tightening narrative, which has been dominating markets, and allow policymakers to orchestrate a softer economic landing.
So, that was the global economy and financial markets last week. In order to discuss the so-called dysfunctional UK bond market, I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank.
Michel, great to have you with us today. During the last two weeks there’s been a particular focus on the UK gilt market, as we’ve been outlining. Even the Bank of England felt the need to come to the rescue and start buying bonds once again. So, is the Bank of England now controlling the yield curve with bond buying?
Michel Vernier (MV): Now, the long end of the UK gilt market, within a matter of days, as you already outlined, Henk, created its own dynamic. On 25th September, 30-year gilts rose 400 basis points within only two days, to over 5%. Now, this was right after the UK government revealed its initial plan of the fiscal stimulus measure, which to a large part, comprised of unfunded tax cuts. So, of course, the rate market was very concerned by this flood of gilt supply, and, as mentioned, long-end gilts moved in a so far unprecedented move in a matter of two days.
The BoE had to respond and intervened with an auction programme to buy back gilts and to relieve the pressure from the gilt market. Now, the bank announced to purchase up to five billion in the very first place of gilts, out of a possible 40 billion, and then has doubled up to 10 billion a day. And, it also announced the temporary expanded collateral repo facility, to provide cash to the banking system.
Now, many investors, and let’s come back to your question, many investors since then believe that the BoE is about to reverse its monetary normalisation and potentially keep long-end yields capped from now on. The pledge to buy long-end gilts, however, had a very different intention, although it was linked to the same phenomenon of rising yields.
The operation had the aim to tackle a quite specific problem that has emerged within the pension-fund industry, which is one of the largest holders of UK gilts besides the BoE. It was finally to prevent further damage by fire sales coming from the pension-fund industry.
HP: Well, as you mentioned, Michel, pension funds have certainly been at the heart of some of the melees that we’ve been seeing. Can you explain, in a bit more detail, why they’re seen as particularly vulnerable to the recent market gyrations, and what’s likely to be the longer-term impact on pension-fund investment strategies, going forward?
MV: Yeah, in particular, it’s the defined-benefit pension funds engaged in liability-driven investment strategies, so LDI, we’re talking about. So, during the period of depressed yields, these pension funds had to find ways to achieve additional returns during the last decade. Pension funds have pledged, for example, long-term gilts as a collateral to engage in additional return-enhancing strategies, largely through derivatives on rates, FX, or other assets.
A sudden rate rise, as seen on 27th September, resulted then in an unexpected shortfall in the collateral value and counterparties, mainly banks, asked for the shortfall to be replenished immediately. That’s common market practice.
Now, this has started a vicious cycle for pension funds, as the pressure to sell gilts to prevent further damage and the pressure of unwinding positions in a hasty manner would have compromised market stability, and this is where the BoE had to step in and buy time.
Now, the LDI industry is around £1.6 trillion peak, so this compares to the UK bond market of roughly £2.3 trillion, so, we are talking about large numbers. What we now see, is that many of these funds are trying to reposition, including unwinding some of these return-enhancing strategies, in order to free up liquidity buffers. So, in the next weeks and months, we may see some liquidations within the typical areas. These pension funds have been engaged in rate derivatives, CLOs, CDO as well, to a degree, property funds, and also the inflation-linked market, which you mentioned just now.
Now, the latter is highly impacted by these pension-fund flows. Lately, we have seen large outflows in a general expensive market, what we would say. However, over time, the pension funds are likely to turn back to their natural habitat, the gilt market.
HP: OK, let’s try and put that all together and think about what it means in terms of the outlook. So, what’s next for the UK bond market? And as you quite rightly pointed out, what can we expect to see over the course of the coming days, weeks, and months?
MV: Yeah, now the UK bond market is exposed to the same environment, we need to divide the UK bond rate curve into two parts, as there are some different dynamics. Now, the direction of short-term yields remains a function of the BoE’s hiking path and what is expected. Now, the MPC still sees the need for large steps and a significant response, given higher aggregate demand due to the fiscal measures. Still, uncertain, of course, how it will play out.
Then, the bank continues to act forcefully due to the prevailing inflationary pressures. Further out, the repercussions from higher rates, especially for the mortgage market but also for corporates, may start to get more weight in the BoE’s decision. Therefore, the chance for a lower peak rate than the 5.75% priced in currently by the rate market, seems more likely in our view, so a lower peak rate, so maybe around 4% perhaps.
The new Chancellor is due to make a statement today, after meeting with BoE Governor Andrew Bailey and the UK Debt Management Office, perhaps the first signal to the market that there’s more willingness to cooperate, and that’s the biggest impact for the long-end of the curve. We have seen, already, a bit of a consolidation because of these first moves. The real test, however, for the market, may only come after the Chancellor sets out his fiscal plan on 31st October.
Rate volatility, at least until then, is likely to remain and rates over 5% cannot be ruled out. But, as the dust settles and the market has a better picture of the government’s fiscal plan, and as the BoE may realise their limitation when it comes to rate hikes, opportunities to lock-in yields may emerge, not only in the short term, but also at the longer end of the curve.
What we need to take into account, for example, is a lot has been priced in with regards to supply uncertainty, and the inflationary and rate-path pressure. If you look at the rate curve in the UK, the 10-year yield, for example, is trading roughly 40 basis points higher than the 2-year gilt yields.
That compares to the situation in the US, where, basically, the 10-year is yielding 40 basis points lower than the respective 2-year yield. That’s basically 80 basis points more premium on the long end already, for the UK rate curve or for the long end. So, there is a bit of opportunities maybe in the long end, but, as I said, in the short term, there is enough potential for further rate volatility.
HP: Well, thank you Michel, for your insights today. It’s clear that until clarity over the UK’s fiscal plan is provided, and, indeed, accepted by market participants, UK asset volatility is likely to remain elevated.
Let’s move on to the week ahead, where the most important data release of the week will be the UK’s inflation report. We expect CPI and core CPI to tick up to 10% and 6.4% respectively. We do expect September to have been the peak in terms of core inflation, as lower goods prices start to assert downward pressure towards the end of the year.
Developments in services CPI, which was at 6% in August, will certainly be closely watched by the MPC.
In the United States, on Tuesday we think that headline industrial production inched up by one-tenth of 1%, month-on-month, in September, following a flat reading in August. On Wednesday, we get housing starts data. In September, we forecast housing starts to fall 8%, showing a return to the downward trend in previous months. This is marked by a downturn in permits in August, as well as inflationary effects causing financial conditions to tighten and housing demand to fall.
In Europe, we’ve got the EU summit on Thursday. EU leaders will discuss the latest developments in relation to Russia’s war of aggression against Ukraine, as well as assess the state of energy prices and security of supply, including market optimisation measures and, of course, progress on demand reductions.
With that, we’d like to thank you once again for joining us. I hope that you found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.
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