Senior Fixed Income Strategist
Summary: Market expectations of a 150 basis points BOE rate hike are not as aggressive as they seem. The real BOE base rate should be positive to tighten the economy, but it is in deeply negative territory. By hiking rates by 150bps, the BOE will only be able to bring the real rate into positive territory if price pressures decrease gradually. That means that the central bank might need to be even more aggressive than forecasted by traders if inflation remains elevated. Thus, we continue to stay cautious, favoring short-duration high-quality bonds.
Markets expect the BOE to hike rates by another 150bps through the first quarter of 2024, forecasting the benchmark rate to peak at 6.5%. Is that farfetched?
I don't think so. The real BOE base rate (the difference between the BOE benchmark rate and inflation) is deeply negative. At -200bps, it's at the bottom of the range it was trading pre-Covid when the central bank was trying to stimulate the economy. The real benchmark rate needs to be in positive territory to fight inflation and tighten the economy efficiently. Therefore, either the BOE needs to hike by 200bps, or it can hike less, hoping that inflation will gradually decline, pushing the real benchmark rate into positive territory. However, the direction is clear: the central bank must be more aggressive than its peers.
As the Financial Times rightly pointed out, long-term real yields recently turned positive. Positive and elevated real yields are mirroring tighter financial conditions. However, are they high enough to affect the economy right now? Probably not.
Real rates are nominal rates minus the breakeven rate. The breakeven rate tells us where inflation will be some years into the future. Let's take the 5-year UK breakeven rate as an example, now trading at 3.99%. Although consumers might disregard where inflation expectations are in five-year times, they know where inflation was in May: 8.7%. Therefore, as they take on a 5-year loan today, they are paying a negative real rate on their loan. Although this point is arguable, it's fair to say that consumers are generally interested in the convenience of taking on debt today, not in a few years, based on market expectations.
That means if the BOE wants to be restrictive, it needs much higher real rates across the whole yield curve, which implies aggressive monetary policies for longer.
Gilt yields have room to move higher and the yield curve to continue to invert as bond futures price more interest rate hikes.
The UK 2-year swap remains elevated, suggesting that 2-year Gilt yields remain compressed despite soaring by 20bps this week. The potential is for them to rise to 6% ahead of the August 3rd BOE meeting, especially as the FED prepares to deliver another rate hike.
Ten-year Gilt yields have also the potential to rise to 5.25%, the 2008 peak level.
The difference between 2- and 10-year on-the-run Gilts
The on-the-run 10-year Gilt (GB00BMV7TC88) offers a yield of 4.65% and pays a semiannual coupon of 3.25%.
If you buy it today and decide to sell it in a year, you will lose -1% if the yields rise to 5.25%. Otherwise, you will gain 9% if yields drop to 4%. If you decide not to sell it, you will receive a coupon of 3.25% every year.
When interest rates rise, the risk-reward tradeoff is more appealing in short-term government bonds. The on-the-run 2-year Gilt (GB00BK5CVX03) offers a yield of 5.4% and pays a coupon of 0.625%. If you buy it today and decide to sell it in a year, you will lose -0.1% if yields rise to 6%, and you will gain 2.13% if yields drop to 4.8%. Suppose you hold the bond until you receive 0.625% every year.
From the example above, the bigger coupon on the 10-year Gilt decreases the bond's convexity, making it less sensitive to interest rate rises. However, the short duration of the 2-year note creates a nice buffer to losses despite the lower coupon.
Are deeply discounted 40-year Gilts a good idea?
The way taxation works in the UK makes it more convenient for bond investors to hold bonds with the minimum coupon and the biggest capital gain to benefit from capital gain exemptions and avoid income taxes. That naturally leads UK residents to pick bonds with the maximum convexity. However, are they a good idea?
The Gilt with 2061 maturity (GB00BMBL1D50) pays a coupon of 0.5% and trades at 30 cents on the dollar. If kept until maturity, it will provide an annualized return of 4.2%. Yet, if you need to sell it in one year and the yield moved by 50bps, you will face a loss or gain of roughly 15%.
While it may be true that rates might decline at a certain point in the future, we cannot be certain at which level they might stabilize. The big problem with holding such an instrument is the loss of opportunity. By now, if you were invested in such an instrument, you would have lost the opportunity to buy much less risky and higher-yielding securities. The problem multiplies as rates continue to soar.
Bond. Long Bond(s)
With real rates being too positive, we see three scenarios: Opportunity to lock in rates at cycle high, government overreach to keep the economy afloat or a complete reset of the economy.
Steen Jakobsen,
Chief Investment Officer
Is a bond bull market ahead? Inflation still poses a risk for investors, but the moment for increasing duration to your portfolio may be approaching towards the end of the year, when central banks might be forced to cut interest rates.
Althea Spinozzi,
Senior Fixed Income Strategist
The furious rate hike cycle has brought gains in the US dollar, but with stagflation risks in Europe and the UK and weakness in the Chinese economy, USD may have more room to run. But a strong dollar could also have repercussions for US growth, emerging markets and commodity prices.
Charu Chanana,
Market Strategist
With the cost of capital rising painfully, stagflation fears are back, illuminating the fragile state of the green transformation, while giving a tailwind to nuclear power, and threatening the growth of AI-related stocks.
Peter Garnry,
Head of Equity Strategy
With supply tightness not only in energy but all commodities, the momentum in commodity prices may continue, pressuring central banks to lower real rates. That could be a good setup for precious metals, including gold, silver and potentially platinum as well.
Ole S. Hansen,
Head of Commodity Strategy
As the pandemic showed, even the US Treasury can experience seismic shifts. With the government increasing the pace of issuing bonds to support fiscal spending, the complex Treasury market and regulatory constraints could spark a liquidity event.
Redmond Wong,
Market Strategist
The tide has turned for bonds. Given the current yields, bonds have become an attractive investment, with added benefits including lower risk than stocks, increased diversification and a steady stream of income unaffected by economic changes.
Peter Siks,
Investment Coach
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