Gilt by Association? Andy Burnham's leadership bid simply avoided market backlash.

This article seeks to unpick whether falling Gilt yields in the two and ten-year are correlated to rumours that Andy Burnham may be the next UK Prime Minister. The conclusion is that the key driver was inflation data, but it is a positive that there was little market reaction to Andy Burnham's potential leadership.

Let’s quickly set out why changes in Gilt yields are far more complicated - and less of a controlled decision - than changes to the base rate. Really here, I am talking about ‘Fiscal Risk Premium’, which is the higher return or premium demanded by investors on their UK debt investment. This is a priced-in, external perception of UK debt. At the moment, the risk premium is high due to concerns about fiscal sustainability and government spending plans. This is why Labour is such a challenging government to have during an inflationary crisis – they are perceived as spenders. Secondly, the Bank of England (‘BoE’) impacts Gilt yields with its stance on the base rate: to put it dangerously simply, if the BoE maintains rates, the perception will be that the BoE views inflation as sticky which perpetuates concerns about the UK economy and the knock-on effect keeps Gilt rates sticky, too.

We can look to understand whether the UK’s debt is more expensive than its peers in part by comparing our Bond Yield Spread - the difference between two-year and ten-year bond instruments. This helps us to triangulate that UK debt uniquely has a premium, and supports the view that investor perception of our economy and policymakers impacts yields. Let’s quickly remind ourselves that the bond spread effectively means the following: steep curve between two and ten year bonds means the market expects rates to remain high; flat curve means economic conditions are expected to persist for years; inverted curve means rate cuts are expected immediately. An inverted curve is typically a recession indicator as rate cuts are usually used to stimulate the economy, but remembering that this applies to accelerated rate cuts in quick succession and not controlled rate cuts over years.

So, the two-year and ten-year spread in the UK, at the time of writing, is sitting at around 66 basis points (‘bps’, translating to 0.66 percentage points). In Germany it is 40 basis points and the US is at 34 basis points, comparatively flatter than the UK’s. So, our long term debt is comparatively more expensive because our curve is steeper. Why? A few reasons. Mostly the Fiscal Risk Premium as set out here and the UK’s persistent inflation. There is also an interesting dynamic following Trussonomics’ misguided mini-budget – pension funds were pretty badly burned and, having previously been an anchor for the long-term instrument, structurally reduced their appetite for long Gilts. This UK now has an oversupply of Gilts at the longer end as Labour continues to issue them heavily to fund the deficit. This problem is unique to the UK and compares poorly.

Note that we also understand our debt is expensive because of the absolute level of yield: our two year Gilt yield (4.13%) is sitting above the base rate (3.75%) to the tune of 35 bps. In a normal environment, this is much tighter at 10-20 bps. However, Germany is actually sitting at a similar level of 35 bps at the moment - the ECB deposit rate is 2.25% and the 2-year Schatz is 2.60%. This is why the two and ten year spread is the more useful comparison here as it isolates the long-end premium that's unique to the UK.

Ok, well, how can Gilt yields be falling then as this is all sounding rather structurally grim indeed? Rest assured, this is actually an uplifting article. Don’t tell me you’re not getting that.

Falling Gilt yields are in part attributable to Andy Burnham’s commitment to the Chancellor’s fiscal rules. This means that Burnham won’t increase borrowing, and he has made it clear that this includes defence spending. If Burnham keeps public spending and Gilt issuance under control, we should not see our Gilt yields get worse. This perception of Burnham’s policy is not stopping Gilt yields on their current downwards trajectory.

Falling Gilt yields are mostly attributable, however, to encouraging data collected by the BoE’s Decision Maker Panel. Let’s establish why this data is important, though, before setting it out. We learned from Reeves’ NIC hike that increases in cost for businesses typically are passed on to consumers through price increases, which is why the NIC hike was inflationary. Similarly, the BoE had legitimate concerns that the impact the Middle East conflict had on energy prices would cause a rise in costs for businesses that would be passed onto consumers.

The Decision Maker Panel’s essentially found that businesses do not expect the Middle East conflict to impact consumer prices, with the expectation of next twelve month inflation actually downgraded to 3.3% versus May’s 3.7% prediction. The knock-on impact of an inflation downgrade is a lower likelihood that the BoE will hike interest rates.

It is worth noting that before the Iran war, there was the expectation that the BoE would cut rates this year once or potentially twice. This was replaced during the war of the expectation of a rate hike. We are now sitting at rate-neutral since the BoE held rates at 3.75% on 18 June. This is a positive story for our economy against a wider backdrop of quite negative perception.

It is positive news that the Decision Maker Panel’s lasso on Gilt yields is not being inhibited by investor perception of Andy Burnham. Remembering of course that Gilt yields are essentially how we capture a fuller picture investor perception of our economy. A changing of the guard, however, does not solve any of our fundamental problems. As I have set out in previous articles, our Labour government has to figure out how to balance the deficit without seeking income solely through further tax hikes. An increase in taxable income by the economy becoming more productive is the ideal solution – if Burnham can solve our productivity crisis in the UK it would be game-changing. My dreams aside, Burnham is going to have to deliver some clarity on his economic policy soon, as the Gilt pressure can only be stayed for so long by his simply changing nothing.