Are UK bond yields closer to lift-off?

Key points:

1. The Bank of England signalled in August that interest rates may be lifted sooner than previously anticipated
2. However, the central bank seems in no rush to lift rates. In 2011, the European Central Bank showed the dangers of hiking rates prematurely
3. The Bank of England has lowered the threshold level from which it needs to taper its bond-buying programme to 0.5% from 1.5%
4. US yields have been higher than UK equivalents for the longest period for over 30 years. Should UK inflation prove to become more sustainable this gap may close
5. With rates low, carry returns appear to offer an efficient way to gain yield as opposed to taking on longer duration.

The timing of when the Bank of England (BOE) starts lifting rates from their record low is a question on many investors’ minds. The central bank seemed to take a slightly more hawkish stance on the possibility of such rate hikes last month.

In August, the BOE signalled the possibility of earlier than previously anticipated rate hikes. Governor Andrew Bailey expected that annual UK inflation would peak at around 4% before moderating again. This in turn likely justifies monetary normalisation sooner than expected.

Caution warranted

Governor Bailey has placed much emphasis on the monetary support and the downside risks to the UK economy in judging monetary policy for some time. July’s higher-than-expected inflation figure of 2.0% after 2.5% in June, on a year-by-year comparison, is likely to provide the central bank with more confidence in respect of when and how to “normalise” rates.

The BOE governor is sticking to his view that the recent increase in inflation is transitory by nature. The central bank seems in little rush to lift rates. In 2011, the European Central Bank showed the dangers of policymakers prematurely hiking rates during a fragile recovery.

Limited scope for hikes

As a result of the BOE’s slightly more hawkish tone, the rate market implies now a first hike by 15 basis points forward to mid next year. That said, there seems no conviction for any rate hikes before 2024 thereafter.

It seems too soon to tell whether the recent surge in inflation is part of the transitory environment or a persistent trend. As in the US, inflation in this cycle is likely to show itself initially with the base effects (higher rates due to the lower price levels seen a year ago at that stage of the pandemic) followed by pent-up demand and bottlenecks (as economies catch up with trend growth).

Lower threshold to start tapering

The uncertainty around economic prospects and inflation is one of the main reasons why the BOE has lowered the threshold level from which the central bank is mandated to taper, or reduce, its bond-buying programme to 0.5% from 1.5%.

Rates of 1.5%, for now at least, seem out of reach and the central bank needed to make this adjustment if it ever wants to start normalising its balance sheet.

Closing the yield gap

UK rates at the long end are likely to be hit by the global backdrop as seen of late. In addition, the correlation between the US 10-year yield and UK gilt yields has generally been high compared with other developed market rates. The exception was 2016, when US rates surged on the back of the “Trump reflation policy”, or policies from the former president aimed at boosting US growth and risking lifting domestic inflation, while UK gilt yields were capped by Brexit uncertainties.

A yield gap opened between US and UK 10-year bonds in 2016 that peaked at 1.6% in August 2018 and now stands at around 0.7%. US yields have now been higher than UK equivalents for the longest period for over 30 years. Should inflation prove to become more sustainable in the UK it is likely that this gap would close significantly, even if not disappearing.

Credit spreads may have bottomed

UK credit spreads, as in many other countries, seem to have reached their lows in the current cycle. Indeed, in the case of high yield spreads they have started to widen slightly.

Less accommodative central bank policies might lead to more muted corporate bond performance. That said, carry returns appear to offer an efficient way to gain yield as opposed to taking on longer duration. UK spreads continue to trade at a slight premium, owing to the market being less liquid and smaller compared to US or European counterparts. In turn, this provides opportunities for UK bond investors.

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