UK struggles to convince bond investors, but US recession risk underpriced

In principle, reducing the tax burden and incentivising innovation are sound ideas. The trouble is the UK is in no position to make a sudden a pivot and another week of forced intervention in bond markets by the Bank of England (BoE) underlines the precarious stability of Britain’s financial system.

Much blame can be apportioned to the cost of the energy price cap for consumers and businesses, the overhang from Covid-19 bailouts and the simple fact the country has been spending beyond its means for decades. All that said, the signal given to markets by the UK government has been reckless, naive and frankly amateurish.

Gilt investors require clarity to assess whether fair compensation is forthcoming for their opportunity cost in lending to the British government. If policy is likely to be inflationary (as is the tax-cutting agenda of prime minister Liz Truss and chancellor Kwasi Kwarteng) then that cost is higher. Given the BoE base rate was setting the bar low, it should not have been a surprise the gilt market threw its toys out of the pram to demand a fair yield.

BoE governor Andrew Bailey already had his work cut out keeping the beast on the leash: rate rises were arguably behind the curve in terms of holding down core inflation. But that caution is the consequence of another historically short-sighted UK government policy: an over-cooked housing market (the government was happy to stoke demand and prices through Help to Buy but not direct the cheap money towards the goal of sustainably increasing housing stock) and sizeably indebted mortgage holders, means rising rates are potentially more punishing to the UK than other major economies.

Timidity is no longer a luxury that will be afforded to Bailey, which must have been evident to the governor as he met with peers at the International Monetary Fund (IMF) and the World Bank in Washington this week. Control of modern economies is largely illusory, but the job of policy makers is to give confidence and keep a handle on narratives.

Risk of contagion

Bailey has underwhelmed in communication, but Truss and Kwarteng have failed monumentally to exude any sense of competence. Discord in the gilt market sparked by the 'mini' Budget required another expensive intervention that will ultimately leave the UK taxpayer on the hook for much more than the original £45bn of unfunded cuts (now slightly less after the U-turn on abolishing the top rate of income tax).

The disorderly sell-off in gilts almost caused the unravelling of several pension funds’ liability driven investing (LDI) strategies, whereby the funds post cash as collateral to meet margin calls on derivatives used to help them match their liabilities to pension scheme members. In response, the BoE announced a £65bn gilt repurchase facility to help pension funds access cash rapidly without forced selling of more gilts at mark-to-market prices under constant downward pressure, a situation that risked sending the financial system into a tailspin.

Much of the £65bn had gone untapped by the start of this week, but the market has been testing the BoE’s resolve to enforce deadlines. Gilt yields spiked again with the ostensible scheme end-date looming, so in response the daily limit of purchases was doubled to £10bn, half of which could be used for index-linked gilts. At the time of writing, the BoE continues to insist the scheme will end on 14 October, but events move rapidly. 

Late on Tuesday Bailey asserted the cut-off is a hard deadline for pension funds to unwind positions and the BoE has reiterated this but, as the Financial Times reports, mixed signals have been sent which isn't helping a volatile situation. Unfortunately the LDI issue is one of many that may arise, in the UK and other jurisdictions, as high inflation forces central bankers to retreat rapidly from easy money policies in ways that are potentially very damaging for other institutions' balance sheets.  

Essentially the BoE must keep a firm hand on the tiller of market interest rates by managing base rate increases to get ahead of inflation, so bond vigilantes don’t set the rates themselves (by selling gilts) in a manner that sets off a chain reaction of destabilising events. If higher rates arrive in an orderly and telegraphed manner, institutions such as pension funds and insurers have time to adjust.

Rising rates will also help defend the value of the pound, which must remain stable against other major currencies to protect sterling’s global purchasing power and prevent the UK importing further inflation. The trouble is, by sending the wrong signal to the bond market, the government has backed the BoE into a corner and now more aggressive action is required to maintain stability, which means sharp pain for the UK housing market might no longer be avoidable.

If so, then there is no soft landing for the UK, and a particularly nasty recession could be on the cards. As far as the impact on companies is concerned, the spread between UK corporate bond yields and the elevated yields on UK government debt signals credit markets have serious misgivings about UK plc.

The spread between the average yield of the S&P UK Investment Grade Corporate Bond Index and the UK benchmark 10-year government bond yield is almost at levels seen at the height of the Covid-19 panic. But the nominal yield, and therefore UK companies’ cost of capital, is much higher. Throw in rising supply chain costs, negative currency effects and potential headaches meeting defined benefit pension scheme liabilities, and it hardly seems like a recipe for growth.

US investors still focus on rates

America’s S&P 500 index may have sold off by almost 25 per cent year-to-date in 2022, but the risk investors have been demanding compensation for is rising interest rates: there will be more turmoil ahead when top billing passes to recession risk.

Look at the read through from the corporate bond market – the stock market’s big brother – and the spreads between yields and the rate investors can get by lending free of default risk to the US government, suggest there is more scope for fear.

Speaking at the end of September, Ryan Brist of Western Asset Management said that although the spread between yields on investment grade credit and US government bonds had widened 45 basis points (bps), only a 20-25 per cent chance of a recession is priced in: “Whether we get a garden variety or more severe recession, we’re going wider [spreads] from here”.

The Bloomberg US aggregate index now has an average yield of 4.75 per cent (constituent bonds have an average life of 8.59 years), which is 21 bps higher than when Brist spoke, but it is clear rates still account for much of the increase in credit yields. The 10-year US Treasury bond isn’t an exact match for the average life of that credit benchmark but the fact those government yields are up 10-11 bps show rates are still the main driver of corporate bond pricing. 

Last week’s non-farm payrolls, which showed the US economy added 263,000 jobs in September, marked a slowdown in the rate of growth. But record low unemployment will do nothing to divert the Federal Reserve from its path of aggressive rate hikes. Tight labour markets exert upward pressure on wages which is inflationary, so another 75 bp rise in the target federal funds rate remains firmly on the cards unless there is strong indication the rate of US CPI increase is cooling when latest figures are published on 13 October.

Raising the risk-free rate

Higher rates mean the prices of assets like credit and equities must fall to imply a premium rate of return above the risk-free government bond yield. That dynamic has been evident with share valuations re-calibrating, but things could get worse. So far, the re-ratings have been due to the ‘P’ in price/earnings ratios needing to drop. But, with a souring economic outlook, the ‘E’ for earnings forecasts will be at risk of downgrade, too, precipitating further price falls.

Credit investors have a more basic question to ask of companies: whether they can remain a going concern. So long as cash generation covers working capital requirements and interest obligations owed to them, bondholders don’t need to obsess about earnings per share forecasts. For investors holding bonds to term, their potential returns are no more or less than fixed coupons and payment of the nominal sum the company borrowed.

On the secondary market, credit yields fluctuate according to both underlying risk-free rates and the spread on top that reflects confidence in companies’ financial health. As with all fixed-income securities, prices move inversely with yields, which means a fall in the capital value of bond portfolios as rates rise and fear of corporate defaults mounts.

Throughout 2022, the end of ultra-loose monetary policy has created a devil’s brew of perfect correlations between the prices of government bonds, credit and equities. All have sold off on rising rates, but the next stage could be worse.

An inverting US yield curve (whereby the rate investors are demanding from government bonds is higher for shorter- than longer-term debt) is a strong recessionary indicator. It occurs because of the expectation rates will be lower in the future in response to markedly worse growth.

Naturally in times of rampant inflation, investors want a high yield for short-dated term lending but, as the economy slows, there is an understanding inflation will subside. Therefore, today’s rates for lending to the US government longer term are attractive: over the full horizon they offer a better real rate than is assumed for rolling shorter-dated investments into newer issue bonds.  

Credit markets in the US have yet to get the recession memo. Corporate America had a healthy balance sheet going into this period of inflation and uncertainty, which explains why bond investors have been content with yields mainly reflecting changing rates. Credit spreads are widening, but remain roughly half what they were when Covid-19 sent markets into a frenzy before the Fed restored order.

In Europe, spreads between euro-denominated credit and German government bond 'bund' yields are at far more extreme levels. Despite massive government intervention, the energy crisis promises to derail many European businesses, driving up costs and creating enormous difficulties for end customers. Bondholders are showing their nerve and spreads are close to levels seen in the most uncertain phase for markets in 2020 at the start of the pandemic.

With no shortage of idiosyncratic risks, and what Societe Generale analysts describe as the continued unravelling of the valuation-led bull market of the past decade, there is a sense there are few safe places for money to hide.