Gilt pressure - nothing all that eye-watering

High tension in the Commons, but inflation and rates are trending in the right direction.

Fundamentally, inflation is slowly edging towards normalcy, with the base rate to follow suit albeit over a long period given the need for demonstrated stabilisation. The healthier our Government, the less speculation can put pressure on what is a fundamentally improved economy in the UK. The message to receive from the below is that our economy is showing fundamental improvements, and the damage will come from more ‘bad press’ and evident poor decision making from UK and foreign governments.

Gilts, the way by which the UK Govt raises debt finance, will become more or less expensive to a reasonable extent by our government’s own doing. Not often do we find so much volatility held by the reigns of a select few, as in recent years.

What is the relationship?

It isn’t news that inflation impacts UK Gilt yields, and the connection is pertinent. In 2022, the UK saw inflation reach its highest rate in 40 years driven by a host of factors the most widely accepted of which are the pandemic, energy, war and oil. When an economy is going through a period of inflation, the central bank will quell its pace with interest rate hikes to discourage spending.

In the UK, Gilts are indirectly linked to the prevailing base rate set by the Bank of England. Rising interest rates make cash held in short-term deposit accounts more attractive because the rate of interest is high over a short period. With Gilts, the minimum term from which the investor is parted from cash is a year. When new Gilts are issued in a rising interest rate environment, the instrument needs to offer a higher coupon (or higher ‘yield’) in order to attract investment.

Gilts range in redemption period from one to fifteen years. There are c.£2.8tn of Gilts currently in issue: classified as ‘ultra-short’ (19% of Gilts in issue); ‘short’ (19%), ‘medium’ (24%) and ‘long’ (39%).

Uncertainty and time therefore impact a Gilt’s value, the longer the gap between issue and maturity, the more the Gilt can either increase or decrease in value because there is expected movement in the base rate. The closer a Gilt is to its repayment (‘redemption’) date, the closer its value will move to its initial face value. In a high interest-rate environment (be that actual reality, or the market’s expectation of the future), long term Gilts need to offer a higher yield to sustain their demand.

Expected near and far- future movements in inflation and base rates impact the yield on Gilts therefore and the cost of issuing debt for the UK Govt. Higher yields are more expensive interest to service for the Govt. The BOE base rate is a matter of national interest, just in the UK as it is across the pond. Hence Trump’s recent blow-up on his Federal Reserve Chair Jerome Powell.

Why does it matter?

Long term Gilts are the mechanism by which the market can speculate and pull forward the cost of debt to reflect longer-term decisions by the UK Govt. Rachel Reeves’ tears in Commons led to speculation that there could be volatility in the UK Govt, and resulted in an increase in yield. This is not a comment on the quality of Reeves’ chancellorship, but on the stability of the UK Government.

Long term Gilt prices are telling us that the future strength of the UK economy is becoming less achievable according to market speculation. This would always be a challenge for a Labour government, because their mantra is more money in the hands of the most. We have just emerged from an inflationary crisis driven in part by government-supplied money in the hands of many. The perception of Labour decision-making puts us on the back-foot.

It is our government’s responsibility to continue to keep a steady hand. Decisions such as NIC and NLW hikes are inflationary, as they are likely to increase the cost base of the companies and therefore the prices of their goods, and will be perceived as such. Then, however, Labour responds to calls for ‘no more inflationary policy making’ with austerity measures – quite logically so – and near mutiny ensues.

All we can hope for is the continued stability and consistency of our government as they navigate, relative to most countries, a solid ship through the choppiest waters of recent memory.

Isn't that nice?