Rachel Reeves and the real reason gilt yields are rising
Few people, even amongst those working in the fixed income space, really understand the private life of a yield curve.
My apologies for not having joined the fun yesterday and for not having written a long and, in parts, witty piece about Chancellor Rachel Reeves’s budget. The good news is that most of what was written – all and sundry had an opinion on the matter, mostly highly sceptical – was distributed electronically, not in print, so at least it was not a case of entire forests. The bad news is that, since the cost of publishing is so much lower and the speed of distribution so much faster, the sheer quantity of opinion was overwhelming. I thought that, with discretion being the greater part of valour, I might step back and let the dust settle. That might take a while but alas.
I am known to be a bit of an old bond dog, so it is not surprising that my WhatsApp is pinging its little socks off with questions and comments on the UK gilts market and on the rather speedy backing up of rates. Many of them refer to the time back in September 2022 when the then newly anointed Tory Prime Minister Liz Truss and her glove puppet Chancellor Kwasi Kwarteng freaked out the gilts market with a shock big state “borrow to invest” budget, which within days had brought them down.
When the 10-year gilt peaked yesterday at 4.52%, it was, if my memory serves me, within 15 or so basis points of the highest yield in the midst of Hurricane Liz. Is this the same again, I was being asked, and would the gilts market put paid to Sir Kier Starmer and to Rachel Reeves in the same way? The answer is of course “No” and “No”.
In September of 2022, the post-Covid spike in inflation was only just kicking in. Bank Rate had just been raised to 2.25%, having in December 2021 begun its journey north from 0.1% and heading towards its cyclical peak of 5.0% which it was to reach in July of 2023. Truss and Kwarteng were of course never given the time to see whether their shock treatment might have worked but it was they who were placed in the stocks and taunted by none more fervently than the then shadow Chancellor Rachel Reeves. They were with monotonous regularity blamed for the high and rising cost of domestic mortgages and I well remember wondering at the time how it could be that the two of them could, if Reeves was right, have also been responsible for equally quickly rising interest rates in America and in Europe. She continued to spout the same rubbish right through until and beyond Labour’s election victory in July of this year and yet nobody ever seemed to want to call her out.
When I occasionally suggest that few people, and I include about three quarters of the people who work in the fixed income space, really understand the private life of the yield curve, I am not joking. And even those who spend their life on the bond trading floors are not entirely to be blamed. In a recent piece, I questioned the benefit of online trading systems when market makers see the “what” but not the “why”. Understanding the flows is paramount. The rest is a computer game.
Years back I worked with a young American called Jake Long, now the highly admired President of the American Woolen Company, who insisted that it was mainly because he owned and used a PlayStation that he had been selected to trade Italian government bonds on the Telematico. That being the first fully electronic government bond trading platform where dexterity with a keyboard was, in his opinion, as important as knowing what one was doing.
In response to my questioning how anybody could trade without knowledge of the “why” as much as the “what”, I got an email from a now retired denizen of the gilts market who added: “Since MiFID 2 opted for best execution through trading desk decisions alone, banks opted to juniorise their sales desks leading to no real connection to PM’s from mature quality salespeople (such as yourself!) as well as running down their research divisions. Buyside thought they would simply hire their own economists, but cost constraints have precluded them from hiring the best available. Result is clear.”
HBOS, by the way, which is where Reeves went to work after her short stint at the Bank of England, was treated by the Street very much as buyside. Proof positive? The lack of deeper understanding by the market-making community of the drivers and underlying market dynamics has led to evermore players chasing market momentum as they lack much of the knowledge that would help them in their positioning. Post-GFC, the great regulatory aim was to reduce the might of proprietary trading, or casino banking as to which it was more commonly referred, although MiFID 2 has in many respects effectively turned even the client-facing parts into something perilously close to being themselves proprietary trading operations. I digress.
The great difference between Reeves’s and Kwarteng’s proposal is that the former has spent four months preparing the market for her big bazooka. The only unknown was how far she would risk diverging from her pre-election promises not to pump up borrowing and pillage the taxpayer. By the time she rose in the House at 12:30 pm on Wednesday, the yield on the 10-year gilt had already pre-emptively risen to 4.21%, up from 3.94% at the beginning of October. The market went into the budget with half-open eyes.
Reeves might have made hay of being the first ever female Chancellor – even my better three quarters who is a specialist in the corporate governance space and therefore well acquainted with the matter of diversity rolled her eyes. But she still couldn’t find a new specifically female path through the budget which nailed the customary huge spending commitments to equally customary Panglossian revenue assumptions, just that with the numbers being so much bigger than usual the margins of error will also be on a huge scale. It is the Chancellor’s job to project optimism and the markets’ role to question them.
Reeves might have once again spouted the myth that she was a Bank of England economist and have even dragged the name of the current Bank of England Governor Andrew Bailey into her budget speech but scratch the surface and you find yet another Oxford PPE graduate of the same ilk as all the others who hang around in Westminster and who are frequently pointed at, particularly by her own party, as being at the bottom of the country’s political malaise.
Gilt yields are rising. And? So are those of European government bonds and of US Treasuries and yesterday the yield on the 10-year German Bund jumped from 2.28% to 2.44%. At the time of writing, it has dropped back to 2.39%. Even without the British Labour government, the 10-year Treasury yield has in a month climbed by 52 bps from 3.74% to 4.26% and the elections have yet to follow. The received wisdom is that, irrespective of who wins residency in the White House, there will be no cap on spending, inflation will reignite, and yields will in all likelihood have to go higher.
So what we see is a very long overdue normalisation of the yield curves – that’s when longer dated stock pays a higher rate of interest than shorter dates – albeit that the prevailing dynamics in the dollar, the pound and the euro bond markets are currently very different. Europe is mired in low growth – the great VW factory closure bombshell should not be underestimated – and, into this, Eurostat yesterday threw another hand grenade by reporting headline inflation across the eurozone having in October backed up again to 2.0% from 1.7% in September.
In the aftermath of the Greek debt crisis of 2010, the ECB, backed by the German government – or was it the German government backed by the ECB? – pulled off one of the greatest Houdini acts in the history of financial markets. Should, however, another such crisis hit the eurozone – Italy has currently been replaced by France as the weakest link – the chances of a replication of the “Unus pro omnibus, omnes pro uno” being achieved are severely diminished.
The States has its own idiosyncratic set of problems to deal with. In the immortal words of one of my dear friends, it has more issues than National Geographic. In an exchange with one of my more illustrious American interlocutors, he wrote to me “Having been in contact with ………, we both agree it’s time to shake the tree. The crypto thing has fcuked up the short end of the treasury market. See yesterday’s WSJ article about SOFR (Secured Overnight Financing Rate). I imagine many are over-levered and the day of recognition is soon upon us.”
It looks suspiciously as though there is currently nowhere to hide. A chum at Bloomberg suggested there is also a lot of selling of Bunds. Gilts and Treasuries out of Tokyo where a few of the major players have been tipped the wink by the Bank of Japan that the softening yen is in need of help before being short of it becomes the hedge funds’ Trade du Jour. So is there selling in all three markets as Japanese institutions begin to repatriate funds? I have no evidence although I would certainly not dismiss the possibility.
The prevailing weakness in stock markets around the globe, led by Wall Street, is currently blamed on some of the Big Tech brigade not delivering the perfect earnings that had been expected although I’d be tempted to look at that as an excuse proffered by those who have had a decent year and who are looking for a reason to take a few chips off the table, elections or no elections.
If there is one thing that makes this United Kingdom – you’re having a laugh – stand out, it is that, in the public eye, the finance minister has become more important than the Prime Minister. That’s not entirely stupid and redolent of a people with a longstanding reputation for pragmatism. In that vein, however, Reeves has trodden on too many toes, has taken too many people for fools.
In an interview with Bloomberg, she ended up admitting that the new tax regime, especially around employers’ National Insurance contributions, would end up in lower pay increases. Was that not the same Chancellor who in the morning had declared that her main objective was to protect working people’s pay cheques? She is in the process of proving that, despite all the glossy working class rhetoric, the government is to an even greater extent than anybody might have feared composed of the sanctimonious white-collar urban elite. Slotting Angela Rayner into the cabinet as Deputy Prime Minister and Lisa Nandy at Culture, Media and Sport is already proving ineffective at covering that up.
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