Bond vigilantism and a side of higher commodity prices

No need to panic yet

The outbreak of war in the Middle East (aside from the distressing human costs) will lead many to question what will be the impact economically both here in the UK and globally. Evidence suggests that UK consumers are expressing some concerns with respect to this: consumer confidence took an unexpected tumble in October, falling to -30 compared to market expectations of an increase to -20. Yet it would be ill-advised to read too much into this until it becomes clearer as to how the geopolitical situation develops in the Middle East.

Initially, one of the key channels whereby the conflict could affect the UK economy would be via the energy market. There certainly have been some moves in global oil and European gas markets since Hamas’s attack on Israel. At the time of writing, UK gas spot prices are up 27% and global oil prices are sitting at roughly $90 a barrel. Context is important, however. UK gas spot prices remain well below levels reached in 2022, currently more than four times less than the previous peak. And, as discussed in the previous rate wrap, in the event that global oil prices continue on their upward trajectory, it is very unlikely that the impact would be anything like that which occurred from gas price spikes following Russia’s invasion of Ukraine. A $110 oil price would only increase UK inflation by 0.5pp at peak impact, according to Bloomberg’s SHOK model.

 For now, providing there is not a significant escalation of the Middle East conflict, the UK economic outlook seems to be much the same as it was at the time of the last wrap, with growth set to be sluggish in the short term. The UK’s PMI composite index for October registered at 48.6 for October. This, of course, indicates that the private sector is contracting given the figure is below 50 but it is hardly a catastrophe. The figure would imply that quarterly growth will decline by just 0.1%. 

Things could be a lot worse. It is striking just how much help the UK economy has received from a better than expected energy market. We estimate over the course of 12 months from July 2023 that the observed and expected pathway of household energy bills compared to a cap of £2,500 for typical use will in aggregate inject nearly £15bn into consumers’ pockets.

Moreover, there was some good news in the latest PMI release on the inflation front, with evidence of significant easing of cost pressures for businesses. And there will undoubtedly be further good news when October’s inflation print is published next month. UK CPI y-o-y inflation is expected to drop like a stone, down from September’s print of 6.7% to a level below 5%, bringing it more into line with European counterparts and no doubt helping improve people’s perception of the UK economy. This fall will be driven mostly by the base effect in energy prices (discussed in previous rate wraps), but we should also see both food and goods inflation easing in October’s y-o-y print. 

Has anything changed with respect to interest rate expectations? Not especially. Cost pressures are easing, inflation is still set to fall below 5% and labour market indicators continue to somewhat loosen. While wage growth remains above what the MPC will be comfortable with (7.8% without bonuses, according to the ONS’s key measure), more timely PAYE data suggests pay awards are easing. This should be enough to stop the MPC from raising rates at the November meeting. Indeed, markets now think it is very unlikely that we will see a further increase in rates at the November meeting, and now believe there is more than a 50% chance that a 5.25% base rate is the peak for this cycle. This is a view that we share. 

Daniel Mahoney, UK Economist

As the title suggests, two themes have been dominating market headlines this month, and for once it’s not led by central bank decisions or comments. The increase in US Treasury yields, which in turn is also dragging global yields higher, has continued throughout October with the 10-year yield hitting the 5% mark. The rise in yields has sprung a debate about what is driving it:

A number of reasons have been cited, and a strong contender is the ongoing economic resilience seen in the US. Despite the mass increase in interest rates during this cycle, we are yet to see a consistent downturn in data. The US looks on course to print a 4% annualised increase in GDP in Q3. Within this we saw another stellar increase in nonfarm payrolls of 336,000 in September, way above the 170,000 expected. A big driver of growth has been the consumer, and even with savings dwindling we are seeing no let-up in the positive trend in retail sales numbers. Retail sales within the ‘control group’ which strips out volatile components increased by 0.6% in September versus a 0.1% estimate. Some suggest the resilience proves that the US economy can absorb higher rates for a longer period, allowing longer term rates to drift higher – thus matching the well-backed view that the neutral rate of interest has and will increase in years to come, relative to the 2010s. The neutral rate of interest is a level which is neither contractionary or expansionary, or put differently, balances the desire to save against the desire to invest. All in all the above supports the narrative curated by global central banks that rates will be held higher for longer.

However, the relatively sudden significant rise in long Treasury yields (c. 70bps in the 10-year segment since the start of September) is not mirrored by a sudden improvement in US data. The idea of a resilient economy has been in focus for months prior – so we can conclude that this cannot explain all of the increase. We also cannot attach the Federal Reserve as a driver either, given its stance has not materially changed since the summer when it first held rates. Whilst maintaining a hawkish stance and keeping one further hike on the table, we have not seen any other changes that warrant the acceleration in yields. In fact, judging by recent comments you could suggest that the Fed is being led by market movements. A few members have explicitly noted the rise in yields and highlighted this essentially does the work for them. Indeed, with yields where they are now, markets do see another hike as unlikely.

What may make central banks more uncomfortable is price action in commodities – which has also been cited as a driver in yields. The conflict in the Middle East has become centre of attention this month, and whilst this can affect all types of assets, the impact on commodity prices is where the focus has been. There has been a jump in prices for both oil and natural gas, unsurprisingly, given the geographical location of the conflict. Not only are countries involved key producing nations (Iran for oil, Israel for natural gas) but key transport links may also be impacted. The Strait of Hormuz is an important route for the transport of oil from the Middle East, as well as natural gas from Qatar which is 20% of the world’s supply. Brent crude currently trades shy of $90 a barrel, lower than highs seen late last month, but more importantly if it persists at these levels or higher (the $100 psychological level will be watched) it will average out at much higher levels than current central bank forecasts suggest. The same can be said for natural gas prices, where in Europe prices earlier this month were at one point over 40% higher than their level a month prior, although have since pared back a little. Overall, markets and central banks will not be too troubled, but risks of further escalation suggest further upside is likely.

To the argument that this may explain the rise in long-term yields, we note that there has been a significant rise in ‘term premia’ which represents the extra yield investors demand to hold the asset for bearing the duration risk (the risks that interest rates may change over the life of the bond). Part of this term premia can be influenced by inflation uncertainty, which has of course heightened. However there is some evidence to suggest otherwise, for example looking at the DKW/KWW estimate of term premium (sourced via Capital Economics), the inflation component has had a fairly minimal impact. Furthermore, we can look at the breakdown of how these nominal yields are formed. The 10-year US Treasury yield is made up of a ‘real’ yield and an inflation component (called a breakeven). What we can see is that the rise in the nominal yield has mainly come from a rise in the ‘real’ yield component, whereas the inflation breakeven has only moved up around 20 basis points since the start of September – so again we cannot wholly conclude that a rise in inflationary concerns explains the rise in yields.

This leads to the last argument, a return of the bond vigilantes. This term is used to describe investors who aggressively sell bonds in response to expansionary monetary or fiscal policy. Another way to put it is investors throwing their toys out of the pram in response to policy they see as unsustainable. We have seen the rise of vigilantes come and go since the 1980s when the term was first created by Ed Yardeni. I won’t list all historical cases where this has been evident, as we only need to look at recent history for a good example, the UK mini-budget debacle in September 2022. This is a prime example of where we see a severe reaction to a set of policies, as a reminder after the mini-budget announcements on September 23 we saw the 10-year and 30-year gilt yield spike to over 4.5% and 5% respectively, and remained volatile for weeks, before calming down after the Bank of England intervened and PM Liz Truss stepped down.

If you are interested in hearing more on the subject of bond vigilantism, you can find our latest special edition podcast in the link below:

With the above in mind, it is plausible that we are seeing something similar in the US. The budget deficit has ballooned again this year on the back of significant spending packages pushed through Congress, which has led to a 12-month rolling federal deficit of over $2tr – whilst the projections over the next 5 to 10 years have worsened too. Couple this with a near government shutdown this month, only to be averted last minute by then Republican House Speaker Kevin McCarthy who partnered with Democrats to push through a short term solution (which cost him his job). Congress will have to go through the same process again next month. Lastly, adding in President Biden’s desire for a $100bn+ package of aid for Ukraine and Israel, it is easy to see why investors are more anxious. Therefore the rise in real yields for sure has been influenced by concerns over increased bond supply (to fund the deficit) and the longer term sustainability of the federal finances.

To conclude, of course it is likely that a mixture of all the above arguments have contributed to the rise in Treasury yields. Economic resilience and the Fed’s higher for longer stance is providing the groundworks to allow yields to push higher, whilst reignited concerns around inflation brought on by the conflict in the Middle East have pushed inflation breakevens higher amid greater uncertainty. But the dominant driver which can explain the sheer acceleration in yields is the rise in the ‘real’ term premium for US bonds, influenced mainly supply dynamics and fiscal uncertainty. As Ed Yardeni said in 1983 “if fiscal and monetary authorities won’t regulate the economy, the bond investors will”.

This Rate Wrap has not focused at all on UK markets, but the above has been the driver of higher yields this side of the Atlantic too, in fact, the 10 and 30-year gilt yields are higher than they were in September 2022, although the increase has been more steady. Nevertheless this is keeping a floor under swap rates which are not pricing in any significant decline in interest rates. Base rate is still expected to be above 4% in 10 years’ time according to current market pricing. Markets still attach a probability of c20% that we may see one more hike by March next year (likely related to a rise in commodity prices), but for the November meeting which will be our focus in the next wrap – it is likely that Base Rate will remain on hold at 5.25%.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg