Last week’s UK market volatility was extreme, with the yield curve ratcheting up by over 100 basis
points at one point. After key Bank of England interventions it settled back to a 70-basis-points rise.
The movement in 10-year gilts was 50% higher than the previous historical highest 5-day increase.
Sterling hit an all-time low versus the dollar, and weakened also by 7% versus the euro, significantly adding to inflation concerns.
The speed and magnitude of the last week’s volatility in the UK markets, particularly in UK Gilts is unmatched in UK market history. The gilt market itself practically ceased to function properly as the scale of unfunded policy action in the government’s “mini budget” was digested. The hit to sentiment, in what was an already jittery bond market, gave rise to a negative feedback loop that pushed the market to extremes and certain pension schemes into a liquidity squeeze. (See diagram below).
Sterling was also hit hard since currency markets tend to be one of the quickest to reflect investor concerns. The scale of the gilt market moves was unprecedented, precipitating the need for the Bank of England to step in and restore order via its market stabilisation function.
The UK Gilt curve’s moves on the critical dates are shown below. The curve moved higher by 1.1% in the middle of the curve and experienced a round trip of over 1.2% at the long end. These yield rises were over 50% higher than any of the previous highest, five-day moves in history. In risk terms, this was an eight-standard-deviation event, an almost meaningless number given there was no historical precedent for it, but “off the charts” nonetheless.
Today’s extremely low Gilt coupons of 0.5% (versus 6-8% in the 90s) mean that their sensitivity to yield moves is significantly higher, a fact that effectively compounds the hit to Gilt prices. In performance terms, the impact was in the order of two-to-three times greater than previous episodes, as the table below illustrates.
Figure 3: 10-Year Gilt Moves
Such moves illustrate just how difficult it was for UK bond and currency markets to establish new equilibrium clearing levels. Things were particularly severe at the longer end – which had been holding on to the belief that inflation, although elevated, would trend lower over the medium term. As confidence in this belief was shattered and with concerns surrounding the unfunded nature of the tax cuts, the market repriced significantly.
The Impact on Defined Benefit Schemes
The speed and magnitude of the moves in the long end impacted heavily on defined benefit pension schemes particularly. Such schemes tend to use derivatives to hedge out their long-term liabilities. These investors, with over £1.5 trillion in assets, dominate the long end of the gilt market. They had to act quickly to meet immediate, and significant, calls for additional collateral to cover margin calls. They were faced with difficult choices: sell assets, deleverage at market extremes, or seek cash contributions from their parent companies.
As fear spread through the market and the execution of these choices added more fuel to the fire, it became necessary for the Bank of England to step in, put a cap on yields and break the downward spiral on prices. As the yield chart above shows this had the necessary effect, restoring an equilibrium of sorts to the longer end, while illustrating just how badly gilt market dynamics had deteriorated.
Figure 4: How Confidence in UK Bond and Currency Markets Unravelled
Source: State Street Global Advisors, Bloomberg L.P. 27th September 2022
The Impact on Short-Term Interest Rates
Having fiscal and monetary policy working in opposite directions further confused and undermined investors’ confidence. The additional inflationary effects of the tax cuts and the associated currency weakness meant that market expectations for rate increases also rose significantly. Expectations for where the UK base rate would peak this cycle shot up, rising from approx. 4.25% before the announcement to over 6% at the height of the concerns last week. While this has eased back somewhat, it still shows the need for base rates to get back to around 5%, another hefty impact on monthly mortgage payments and households’ dwindling disposable incomes.
Sterling: Problem or Opportunity?
Sterling - already quite weak against many of the major currencies, and particularly versus the dollar - took the early brunt of the market moves and lurched to an all-time low against the USD last week.
With a large current account deficit of over 8%, exacerbated by recent energy price rises, this weakening in the currency added to the inflationary impact and undermined confidence further, sparking the large rise in rate expectations. While currencies are volatile by nature and can remain at very high levels of under/over valuation, they do tend to revert towards fair value over the medium to longer term.
As the valuation chart below shows, Sterling has been undervalued against the major currencies for quite some time. Its weakening post Brexit has not recovered, with investors demanding a higher risk premium given the political and economic uncertainty that has since ensued. However, the latest move takes the level of undervaluation versus US dollar to a completely new level.
Source: SSGA calculations, as of 26 September 2022 Past performance is not a guarantee of future results.
Admittedly, it’s not only about Sterling, since the US dollar has now become a high-yielding, safe-haven currency globally, propelling it to levels of overvaluation of more than 20% versus the euro and more than 49% against the yen.
On this long-term basis, Sterling is indeed very undervalued and hence may present a buying opportunity. However, as the events of the last few days illustrate, risks and volatility remain high thereby underpinning USD preference, and while there are plenty of downside risks, there is a lot in the price of the Great British Pound at current levels.
So, what are the investment implications of this tumultuous week?
The immediate impact is that the Bank of England base rate will need to be raised higher and faster. A 100 basis point hike from the Bank is now fully expected in November. Beyond that, it is difficult to predict given the impact that this, and energy costs will have on consumption this winter.
For the Gilt market, thankfully some stability has been restored by the Bank of England’s intervention already, however, longer term, the fiscal and funding concerns remain and will keep pressure on yields from a fundamental perspective. Furthermore, the attractions of the UK Gilt market to international investors, upon which much of the future funding depends, is likely to have been dented. In summary, what happened last week is not the behaviour, or performance that investors would expect from the bond market of a large, developed, mature economy.
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