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One of the most striking market moves last week was in UK government bonds. Gilts tanked on Thursday, led by the shorter maturities, after traders and investors caught a sniff that the Bank of England is leaning towards raising interest rates, not cutting them as it had indicated before the war in Iran kicked off.
The facts changed and the Bank changed its mind. No shame in that. And it has not committed to any particular course of action from here. But all the same, the scale of the hit to gilts was just enormous. On Thursday, the two-year yield added 0.3 percentage points (!). Lots of countries’ bond markets are shifting, but no one does it quite like the Brits. German Bunds and US Treasuries added about half of the UK’s extra slug of yield that day. On Friday, it got worse, somehow; gilts added another 0.2 percentage points or so. A contact of mine texted me Friday afternoon with one word: “HELP”.
The market had taken one cut off the table going into Thursday’s BoE decision. But now it says there is an 85 per cent chance of a rise in April, making it three rises fully priced for this year and a chance of a fourth. Seriously? In an economy that grew 0.1 per cent in real terms in the fourth quarter?
It is worth asking why the gilts market has become the global whipping boy. Our indefatigable colleagues on the news side did just that on Friday. Here are some additional thoughts:
One: The long, dreary shadow of Liz Truss and Kwasi Kwarteng. It may sound slightly silly, three and a half years later, to keep blaming late 2022’s mini-budget of mass destruction, but gilts investors, particularly those outside the UK, still cite it to me as a reason for additional caution in this market.
Two: Picking off the stragglers. As I wrote in my column for the weekend, the UK does have certain vulnerabilities around debt levels and fiscal wriggle room that other big economies don’t have, or at least not on the same scale. If anyone can make stagflation happen, the market is betting it’s the UK.
Three: Blame hedge funds. They are an easy target, but let’s unpack that idea: First off, it should be noted that sovereign debt management offices around the world actually like hedge funds. They have a bad rep, but actually the hedgies show up when debt is issued, they often act quite similarly to so-called “real money” (insurers and pensions), they provide liquidity to secondary markets (which was particularly useful in the “mini”-Budget shock of 2022). Also, they help to make up the void left behind from certain types of pensions that are just not hoovering up long-term debt in the same way any more.
As the OECD noted in its big debt report the other day, “price-sensitive” investors are an increasingly important part of the investor base in both government and corporate debt markets. On that front, hedge funds are right up there. Here is a nice OECD chart that maps various buyers’ tendency to hold bonds to maturity against their appetite for long-duration bonds and their sensitivity to price:
Salman Ahmed, global head of macro at Fidelity International, told me this may be a problem when markets get tricky, as they clearly have done here.
“The composition of the gilts market has weakened,” he said. “There’s a lot of hedge fund participation and the price is paid in periods like this. The market function is under stress.”
If Salman’s right I’m still not sure there’s much we can do about this. Like basis traders in the US Treasuries market, hedge funds may be flighty but we’d miss them if they were gone.
