The December 2021 low for the UK’s ten year gilt yield was 0.7%; it now stands at 1.5%. In America, the low was 1.3% with the ten year US Treasury Bond now trading on a yield of 2%. The long-dated 4.5% of 2042 gilt fell from £170 in December to £152; which is down an uncomfortable 11%.
The average UK spread has widened out as well. This is the average extra yield that you get from owning a UK corporate bond over and above an equivalent maturity gilt. At the end of September the average spread was 1%; it’s now 1.4%. Spreads widen to price in a greater chance of default which is what you see in recessions.
In the last edition of Prospects, I wrote that “I aim to be more inclined to below benchmark maturities.” Shorter dated bonds are less susceptible to interest rate movements; the 2.75% of 2024 gilt fell only 3% by contrast.
We now ponder what is next for the bond market and that is very much driven by inflation. The market takes a pretty dim view of the UK’s inflationary expectations and is pricing in the retail price index (RPI) to average 4.7% over the next five years. A person earning £30,000 will, this year, see their take-home pay plunge by £1,660 thanks to soaring living costs, stagnant wages and tax increases; and so the big question is whether this is going to be enough to take the heat out of inflation by reducing demand for goods and services.
Economists talk about UK inflation peaking at c.7% by the end of spring and then falling back. That ties in with my calculations and takes into account base effects which are driving energy’s strong contribution to inflation. I see inflation falling back to 4.9% in 2023, 4.4% by 2024 and then 3.6% for 2025 and 2026 on the basis that inflationary expectations don’t become entrenched and that the long term drivers of weak inflation that persisted before COVID-19 re-emerge as dominant.
These are the long-term drivers like Amazonisation, job rotation, capex and investment driving productivity and on-going globalisation. In a lowly unionised world, seeing the elder cohorts of COVID-19 job quitters back in the market place would reduce the propensity of the consumer price index (CPI) to iteratively propel wage inflation higher as well. The contrary view is that central bankers panic, raise rates too far and push the West into a recession.
A contrary opinion is that all the money we have saved by buying less services, like travel and holidays abroad, has been channelled into buying goods which is why demand is greater than supply for items like used cars; I see this as being a short term phenomena.
If you agree with me, then stay short dated with bond maturities and look to bonds rated in the BBB to B space. If not, keep your eye on the yield curve inverting (i.e. long dated yields being below short dated ones) and be ready to jump into longer dated, high quality bonds for the next recession.
Illustration by Emily Nault
