Britain is no stranger to bond market ructions – and given our choppy political waters, perhaps deservedly so. Last week, Luke Hickmore, fixed income investment director at Aberdeen, warned that “markets haven’t forgotten 2022”. We might be four years on from the ‘mini’ Budget, but gilts are still trading at higher yields than in other comparable economies.
But as the chart below shows, 10-year yields have crept upwards in other G7 economies over the past six months, too. With the exception of Italy (which had the Eurozone crisis to contend with), G7 yields are approaching their highest levels in almost two decades. The recent rise in government borrowing costs isn’t just a UK story.
Why bond yields are rising
As conflict in the Middle East escalates, so do fears about a new wave of inflationary pressure. The oil price now stands at around $90 a barrel, up from $62 at the start of the year. These triple-digit prices can act like a tax on households in the G7’s net energy importers (Japan, Italy, Germany, France and the UK), pushing up fuel and utility bills. As these effects ripple through supply chains, they feed into higher prices for metals, plastic, paper and food.
The bloc’s net energy exporters (Canada and the US) won’t escape unscathed, either. Rising oil prices boost energy companies, but they leave households and other businesses facing higher costs, too. Analysts at RBC estimate that for every $10 increase in oil prices, US petrol prices rise by around 30¢ per gallon. For bond investors, this inflation is bad news, eroding the future purchasing power of the fixed income that bonds provide. It also makes it more difficult for central banks to cut interest rates.
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A closer look at the yield curve
Falling interest rates are good news if you are an existing bondholder. Your asset locks in higher coupon payments than newly issued bonds, and looks more attractive as a result. But when investors expect rates to remain higher for longer, these older bonds become less appealing. Demand weakens, pushing bond prices down; yields, which move inversely, climb upwards. For investors holding government bonds for one, two, or even five years, changes in interest rate expectations can have a big impact.
But if you are holding government debt over the longer horizon, you also need to consider long-run inflation risks, the government’s fiscal sustainability and the term premium – the additional extra compensation required for locking your money away for decades in the face of all these uncertainties.
Today, all G7 governments have high debt burdens by historical standards. In Japan, the figure is over 200 per cent of GDP; in Germany, it is close to 70 per cent. This means that governments are issuing more debt into already well-supplied markets, just as the inflation outlook is becoming less predictable. And they may find that investors are no longer willing to lend without more compensation.
The international nature of bond markets can make the pressure more acute. Since investors can move money across borders so easily, governments in effect compete with one another for global capital. If investors think one country offers better returns or greater stability, governments elsewhere may have to offer higher yields to attract buyers for their debt. Around a tenth of Japanese government debt is held by foreign investors. In the UK, the figure is closer to 30 per cent.
The kindness of strangers
This reliance on ‘the kindness of strangers’ means that domestic political turmoil can provoke a harsh response from global debt markets. Claudio Wewel, FX strategist at J Safra Sarasin, notes that the average tenure of British prime ministers has shortened so much since the financial crisis that we are drawing comparisons with Italy. Investors are raising concerns over fiscal sustainability in the UK, “given the often-observed correlation between political instability and fiscal instability”, he said.
Meanwhile, Aberdeen’s Hickmore calculates that every percentage point increase in 10-year gilt yields will cost the government about £10bn annually in debt interest by 2030. In the UK, the 10-year yield is already around 0.4 percentage points higher than it was at the start of the year. He suggests that even the perception of looser fiscal rules could add another 0.5-0.75 percentage points to the total. Global inflation fears are colliding with Britain’s political vulnerabilities – no wonder gilts feel so exposed.
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