No, current gilt yields don’t justify Liz Truss, please don’t make us explain it again

Liz Truss’ prize is eternal vigilance.

Here in the UK the economy is not doing very well and a lot of the numbers are not as one would like. While other major Western economies brace for the end of rate hikes or attempt unnecessarily soft recessions, Britain is still stuck in the active fight against inflation.

A corollary of this is higher yields on UK government debt. Earlier this week, the yield on sensitive two-year gilts hit its highest level since 2008 – significantly (or not!), higher than during the LDI/Truststerflux/”Fiscal Event” that ravaged and destroyed British markets last autumn and led to Truss’s ignominious defenestration of high office.

A certain group of people have been extremely 🤔 about it, making wise comments like “Oh interesting, so are we going to fire Rishi Sunak then?”.

Many of these people are either confused, willfully ignorant, or dishonest. Some of them have newspaper columns.

We don’t want to feed the trolls, and we’ve already covered Liz Truss’ one My part in my fall (and associated coup conspiracy theories). But since people without newspaper columns might reasonably wonder why things are different now, here are some tentative answers.

The stupid risk premium is not as high

One important reason why the September 2022 yield peaks cannot be compared to the June 2023 yield peaks is that they were in September 2022 and now we are in June 2023.

A key concept in global markets is relativity: for an investor who has already decided to buy government bonds, the price/yield of gilts matters less in absolute terms than in terms of comparison with alternatives.

That’s why when we tried to calculate the UK’s so-called ‘moron risk premium’ – that is, the extra return the government was forced to pay lenders because Truss was considered as a liability – we used spreads, especially on German Bunds, as a metric. This way you see how the return has evolved against a competitive asset.

This is the perfect time to note that the return on 30 years gilts – which were the bonds at the center of the LDI crisis, not 2yrs – aren’t quite back to those Truss-y highs:

They are still quite close. But looking at them in terms of spreads over Bunds (which are more comparable than US Treasuries due to relative economic strength), there’s still a long way to go:

It’s not pretty, but it’s nowhere near as bad as September. By applying our Moron Risk Premium formula ([gilt yield]–[Bund yield]—[1pp of baked-in UK risk premium]) and then multiplying that by the Office for Budget Responsibility’s ready-made figures on the cost of an additional percentage point of cash flow returns, we can see that there’s still a good chunk of that which we later called the “toastal nation bonus”:

What is less clear is how much of the Moron risk premium that underpins these additional costs now stems from government behavior, relative to, say, the UK’s worryingly sticky inflation.

Speed ​​Matters

As we mentioned in our Trussay analysis, the thesis that the Bank of England was responsible for the LDI crisis – by initiating quantitative tightening at a time when the government was increasing borrowing, thereby flooding the securities market with Status – relies on not being able to read a graph.

Specifically, crisis shock moves were spurred, as intraday data shows, by the things that Truss and quickly jettisoned Chancellor Kwasi Kwarteng were doing and saying, such as introducing policies with unlimited costs, teasing the unquantified tax cuts and the dismissal of senior civilian officials. servants.

Rates have increased quickly as a result, and it is this speed that has caused such problems for LDI program providers (who would in theory benefit from higher returns).

At what speed? Well, here’s how much 30-year yields have risen, to their peak, over three days during the LDI crisis, compared to how much they’ve risen over the 161 non-weekend days since Sunak became Prime Minister :

The national macroeconomic environment has changed

Relativity does not only matter in terms of links. The most fundamental factor driving gilt returns is UK interest rates, as set by the Bank of England.

As Barclays FX strategist Lefteris Farmarkis put it in a note this morning:

The sharp upward revision in UK rates in the wake of strong labor market data brought up memories of last September’s rate selloff, as well as a question about the reaction of the pound. Indeed, BOE policy expectations are now close to what appeared to be high highs at the height of the LDI crisis, albeit from a much higher Bank Rate starting point. . Interest rates across the curve are also hovering around September 2022 highs.

Apparently, on the contrary, the dynamics of the current interest rate adjustment are very different. Indeed, this week’s movement was exclusively driven by a change in key rate expectations, unlike last September, when the change in political expectations was accompanied by a sharp rise in term premia.

Here’s what those changing expectations look like:

A useful measure here would be to take the expected terminal rate as a time series and spread it over the returns, but the peak is a moving target, so it’s not easy to do (if so, please let us know). Yet even looking at the appreciation of the Bank Rate relative to, say, 10-year yields since the bull cycle began in late 2021, one can see what an outlier last September was:

The other macro factor is the mighty British pound, with a total return of around 7% so far this year – the best of the G10 currency group and third best among the majors.

For half-understandable reasons (the gilts nearly caused a financial crisis, unlike the pound), the fall of the pound to an all-time low against the dollar during the LDI debacle is often ignored.

Yes, the recent strength of the British pound is closely linked to a relative strengthening of gilts, as the international demand for gilts is driving up the demand for pounds. But even if he treads water, it would stand in stark contrast to the almighty efforts to get rid of British assets that Truss has unleashed.

Aggressive political expectations and persistent inflation make the pound an attractive carry market, but Farmarkis thinks Brexit will limit the extent of the pound’s rally:

A more fundamental limitation to a significant upside, especially against the euro, relates to the very narrow post-Brexit range in which the pound has traded. In our view, this reflects significant Brexit premiums, which are likely to remain high over the medium term.

The outlook is still uncertain

Deutsche Bank released an interesting chart earlier this week showing how the Bank of England has struggled to bridge the gap between current interest rates and market expectations for the terminal rate:

Shreyas Gopal and Sanjay Raja of Deutsche wrote:

[The] The market had believed that the BoE was gradually moving in the right direction, with the spread between the key rate and the terminal rate set by the market narrowing from September to March. Much of that hard work has been washed away of late, however, with prices suggesting the UK is just as far away from its landing zone as it was at the end of last year.

By comparison, the European Central Bank and the US Federal Reserve seem nearly complete. After today, WIRP prices suggest the ECB could still have a move higher, while mixed signals from Jay and the gang leave open the possibility of the jump becoming a pivot.

And there is still plenty of potential for danger in future UK CPI readings: following the peak of the pandemic (complicated, no doubt, by the much higher volatility of inflation), economists are simply become less adept at guessing how prices move, tending to underestimate:

Higher interest rates are widely seen as an unvarnished evil in the UK media, which is unfair. Here, from the Telegraph, is an example of how the policy plays out:

The Prime Minister’s spokesman told banks to look after customers struggling with soaring costs.

He said: “The Chancellor has made it clear that he expects lenders to live up to their responsibilities and support all mortgage borrowers who are struggling at this time.”

The spokesperson added: “There remains a wide range of mortgage deals available to the public, but we know this current situation may be concerning for some homeowners and mortgage holders.”

To which the response of many UK tenants was widely (quite rightly for many): 🎻👌

So, is a mortgage crisis looming? Not in the short term, says Samuel Tombs of Pantheon Macroeconomics:

[While] new mortgage rates will rise further over the next few months, only about 7% of all fixed rate mortgages will be refinanced in the third and fourth quarters, and only 30% of households have a mortgage

The pain, on the contrary, will be constant and will last for several years. All of this adds to the conditions under which the UK could face, at the very least, continued stagflation, or possibly inflation and a mild recession. Which one is:

– more or less what has been clearly on the cards for a year and a half
– obviously shit
– not at all comparable with Truss which nearly crashed the economy

Got it?