Sterling gets a breather, but no such luck for Gilts ......

Wednesday 12th October 2016

  

Sterling gets a breather, but no such luck for Gilts ......

ref:- "Gilts hit by volatility in wake of pound's fall", The Financial Times, Markets and Investing

Funny old things, markets ..... take Gilts, for example. In the aftermath of the Brexit vote, the UK's government bond prices moved sharply higher and with prices moving inversely to yields, record low yields were posted on August 12th. The 10yr Gilt returned just 0.52% on that day, and whilst bond markets globally were being boosted by a flight-to-quality factor the UK's debt was in particular demand in expectation of further easing from the Bank of England to counter the difficult economic conditions likely in Britain's new future. Exactly two months on, and Gilts are taking a pounding and yields are through the roof (comparatively speaking). The 10yr yields 1.05% as we write, and remarkably the cause of Gilt yield both falling and climbing so rapidly is in essence exactly the same  --  Brexit.

 As we've mentioned a couple of times recently, the plunge in the value of Sterling (19% -v- USD since the referendum)) is the particular Brexit effect that's responsible for the mayhem in the Gilt market. There are benefits to a weaker currency, most crucially how it affects exporters. That's the reason why the economic data has been surprisingly strong recently and why the FTSE 100, heavy with international companies as it is, has been making new intra-day highs. But the flipside to that (and what a flipside !) is that Britain is a huge net importer. Weak Sterling means that imports cost more and thus are inflationary, and we know the inflation is BAD NEWS for bond markets. It eats into the fixed returns offered by bonds.

Beyond that, the foreign exchange risk represented by a volatile and vulnerable currency is a deterrent for foreign buyers. That in itself weakens the bond market and the danger is that it will only exacerbate what is already a big problem for the UK  --  that of its enormous current account deficit. Britain has been able to finance that deficit by attracting very high levels of investment from overseas  --  anything that jeopardises that ability can only add fuel to the fire.

As it happens, Sterling has managed to put a (temporary?) stop to the bleeding today, even if Gilts haven't. The consolidation in the currency (if you could call it that after a few hours) is being put down to PM Theresa May relenting far enough to allow Parliament to have a say in Brexit negotiations. The theory is that this points to a "softer" Brexit. We're sure people are right to ascribe Sterling's respite to this, but are not at all sure that the theory stands up to close examination. No dealmaker could possibly reveal the details of his strategy in advance, in Westminster or anywhere else, without scuppering their chances of successful negotiations. We can foresee unseemly arguments in the House that won't do Sterling, Gilts or anything else much good.

It's just one point of view of course, but there are those in financial markets who are getting a little nervous about Mrs May  -- that probably won't bother her too much, the general public reminded financial markets of their place in the pecking order back on June 23rd. But some might say that after a mildly impressive start her recent utterances are of much more concern. "Brexit means Brexit" is absolutely fair enough, but she seems to be setting about things with all the zeal of a new convert, even if we're not at all sure if she was ever really a "Remainer" in the first place. In what looks like a nod towards populism, the Immigration issue is being pursued to the apparent cost of hopes for workable trade deals. It would be one way to go of course, but her stance seems the opposite of business-friendly and may one day be reflected in the price of Sterling and Sterling-denominated assets.

Still, that's probably for another day ..... for now, we can ponder the travails of the Gilt market and note that it's not all bad. Higher yields are a godsend for pension funds and insurers who desperately need more profitable fixed returns to meet their obligations. There's a school of thought that reckons that yields on Gilts could go higher yet regardless of the price of Sterling. Globally bond prices are on the retreat as markets question both the feasibility and the desirability of further central bank easing, and in the UK there is the additional prospect of fiscal spending replacing former Chancellor George Osborne's austerity and drive towards a balanced budget. The money for any of these spending projects would of course be raised by the issuance of new Gilts and the possibility of that kind of extra supply is doing nothing for Gilt prices.

Already the rise in Gilt yields means government borrowing would be a half per cent dearer than two months ago, though still very cheap by historical standards and if you want to borrow and spend, then now's still a very good time to do it. But new Chancellor Phillip Hammond has distanced himself from any kind of spending binge. That might be a relief for the Gilt market but so far, as in so many other areas, you can't really be clear about what this government's intentions truly are.