JP’s Journal: A Life of Service and Wisdom

Fixed Income

“Send not to know for whom the bell tolls, it tolls for thee”. In his simple poem For whom the bell tolls, the great metaphysical poet John Donne reminds us that no man is an island and that time is the great equaliser.

 

I never met Queen Elizabeth II, but I do have several photographs of her with my late father, in his capacity as Chairman of the Cheshire Agricultural Society. I think she had a strong affinity with farming and certainly seemed to be enjoying herself at the County Show.

 

A monarchy seems a strange concept to many people today, but it worked brilliantly under the Queen. Listening to past Prime Ministers on Thursday night recounting their interactions at weekly meetings showed a side to monarchy that largely goes unseen. As a person she was generous and welcoming by all accounts but, more importantly, acted as a confidante to many Prime Ministers. With tremendous knowledge of world affairs and an exceptional work ethic, Queen Elizabeth II set standards for constitutional monarchy that will be difficult to match.

Response to the energy crisis

With the sad news of her passing, the appointment of a new Prime Minster and the policy response to the energy crisis are easy to overlook. But they impacted markets. In a bold decision Liz Truss decided that the best way to address the energy price surge is through a freeze on the Ofgem utility price cap (based on a typical household – if you use more, you pay more). For two years the cap will be set at £2,500. In addition, there will be a six-month cap on energy bills for businesses with further targeted support after that if required.

 

On the face of it, the Prime Minister has decided that financing the cap through general taxation is the fairest approach. So, what does it mean for UK debt levels and are bond markets right to be concerned?

 

There is some good news. The cap will mean that the rampant inflation rates speculated by several US banks last week are unlikely to come to fruition. Rather, it is likely that the peak in inflation will now come later this year and under 12%. I think this was a priority for the Government: to bring down inflation expectations and prevent a wage/price spiral. The second bit of good news is that this fiscal injection will moderate the recession. I still believe that the market is a bit complacent about the slowdown, but lower inflation means that real incomes won’t fall as far now. It could shave 0.5% off the decline in output. But it will come at a big cost.

 

 

While the policy will reduce inflation in the near term, by supporting economic activity, it will probably boost medium-term inflation. This is likely to toughen the resolve of the Bank of England (BoE) to increase bank rates. Put simply, looser fiscal policy will result in tighter monetary policy. So, what is now priced into markets? If we look at the UK rate curve, we can see that we are pricing in 4.25% for the second quarter of 2023. I don’t think we will actually get there as the recession starts to bite.

 

This should be good news for government bonds: economic contraction is usually associated with falling gilt yields. But there is a twist here. Fiscal largesse will lead to bigger budget deficits and a higher stock of debt. If I conservatively assume that £60bn of business support remains off the government balance sheet (funded through state-backed commercial loans), there remains close to £100bn to be funded. What this means is an approaching triple whammy for gilt supply. Higher debt due to economic recession, higher debt to pay for the energy price cap freeze and the overhang of Quantitative Tightening (QT) that the BoE is planning to roll put. It’s even worse than this, in reality, as the Prime Minister has already signalled the reversal of previously announced tax hikes.

 

In practice it means that the UK government bond market will see a lot more supply in coming years. How much? Well, it depends on gas prices and how much the support turns out to cost. It will also depend on the BoE. Does it stick to a policy of QT or recognise that conditions have changed and hold off? Recent history suggests that transparency (telling the market what it is going to do and then doing it) trumps pragmatism (adapting to changing conditions). Both approaches have strengths and weaknesses. But selling an extra £40bn of gilts a year into an unreceptive market at a time when underlying issuance has been boosted by fiscal responses will be a challenge.

Bond yields continue to rise

In markets, bond yields were higher last week. US 10-year yields ended above 3.3%, while German and French equivalent yields moved towards 1.7% and 2.3% respectively. UK rates were volatile, but closed near 3.1%. Despite the energy price cap news, UK implied inflation rose at medium and longer maturities, reflecting concern that the fiscal injection would boost inflation. Credit spreads were broadly unchanged and there were signs that the relative freeze in issuance was abating. Despite the coming global slowdown, I continue to see value in credit spreads.

 

Celebrate a life, shed a tear for the tolling of that bell, and move forward.

 

 

 

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.

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