The price of lockdown

The office for National Statistics (ONS) has released its inflation data for April. The Core Price Index has fallen from 1.5% in March to 0.8% in April, which is the lowest number since August 2016 and reflects the economic impact caused by the first month of the coronavirus lockdown.

Interestingly, the price information on 16% of the typical basket of goods that the ONS analyse could not be collected due to difficulties caused by lockdown restrictions, or it is simply not currently available. This includes, for example, what a plumber would charge or what a cinema ticket would cost – activities which are not allowed at present.

For these non-available items, the ONS has substituted-in the average inflation rate of the rest of the basket that can be observed. Given that energy costs and the oil price are significant drivers of inflation, the Ofgem reduction in its default tariff cap and the global slump in oil have resulted in a compounded downward effect on inflation.

Inflation should trough around August, with some analysts believing that we are heading towards a zero rate. But is this likely to bounce back later in the year? I think that the key influencing factor to watch, as mentioned previously, will undoubtedly be the oil price.

Yet, if we are at a stage where the ONS has full data on the inflation basket we will also have exited the lock-down as we know it now. Businesses will have clearer information to set their prices and it will be intriguing to see the resultant variations we get on inflation rates.

It is not outwith the realms of possibility that prices will continue to fall across the board. Yes, there will be stock to be shifted and clothing retailers in particular could be inclined to offer discounted sales. However, where there are supply issues in meeting the demand of consumers as they come out of lockdown, the consequence may be some upward pressure on the price to be paid. It is this nuance which may not be immediately picked up amongst the predictable clamour to prematurely proclaim the end of inflation.

Sign up to receive our weekly BondTalk email

Bank of England purchases – why so fast?

In times of crisis, we now know the playbook by policy makers. Governments will spend it and the Central Banks will buy it. The more “control” (or as they would call it “coordination”) that these two arms of policy have, the more effective it is. In the UK, we have seen a relatively swift and effective response by the Treasury and the Bank of England (BoE) since the crisis took hold.

We do not yet know how many Gilts will need to be issued in 2020/2021 to finance the deficit on the day-on-day spending, but with commitments directly linked to covid-19 spending and the need to cover workers’ wages, unemployment benefits/sick pay, grants to SMEs, tax breaks for some etc. etc. – along with “normal” spending and the inevitable drop-off in tax receipts – it is not impossible we could be looking at Gilt issuance of around £250bn to £300bn when all is said and done.  We will get a better picture of this on the 23rd April when the Debt Management Office (DMO) announce the new remit for the year. The previous largest ever year for Gilt supply was 2008/2009 where £227.6bn of Gilts were issued.

Now, if we assume the DMO – who control the sale of Gilts to the market – spread out this issuance over the year, we are looking at a run-rate of £20bn to £25bn a month in issuance. The other side of this is the BoE buying we will see through the new QE programme (announced two weeks ago). We expect this to amount to around 190bn of Gilts and 10bn of Corporate QE. Based on the current run-rate of buying (c. £13.5bn a week), the Bank could well be done by June/July 2020.

This does raise the interesting prospect that if the QE programme is done by the summer – and the DMO smooth out their issuance plans – the burden will fall on the ordinary Gilt investor to buy up the increase in supply into Q3/Q4. Given this potential imbalance, some have asked why the Bank has acted so quickly in its QE buying. However, to us the approach seems eminently sensible.

In the event that we are not back to a degree of normality by the second half of the year – which may allow for a more fiscally prudent approach – and if the economy is instead assumed to be still faltering, we would firmly expect the Bank to have dusted down its policy playbook and engaged in further and perhaps unconventional policy action. Under this scenario, fears over any supply overhang from the DMO will prove to be short-lived.

Better to be early to the party than not attend at all.

Sign up to receive our weekly BondTalk email

Will the new boyfriend be any more reliable?

The Bank of England had the opportunity to cut rates on Thursday and chose not to. Their economic assumptions can only be described as grim, and yet still they chose to leave interest rates unchanged. To put their forecasts in context, the BoE has 0% GDP growth forecast in the fourth quarter of 2019 and is guiding for 1.5% CPI in one year’s time. Members are also clearly cognisant of the increase in spare capacity in the economy and what impact this will have on inflation.

If the hard data continues to disappoint, should we expect the MPC to reconsider? Maybe, but we would have to see significant disappointments now to warrant easing rates. For now, the BoE appears to be on hold, and as a result we should expect the gilt market to unwind some of its recent (absolute and relative) strength. We should also maybe expect a renewed Carney “unreliability” discount to creep back into gilts versus other rates markets, despite his departure.

Sign up to receive our weekly BondTalk email

I hope you like a fan chart!

The last two speeches from Mark Carney and Gertjan Vlieghe makes me wonder if the Bank of England (BoE) are preparing us for a change to come at the August Monetary Policy Committee (MPC) meeting.

BoE economists factor-in both government policy and market-based interest rate projections into their models, and then create projections of GDP and inflation. However, this approach raises a number of issues that the Bank is clearly wrestling with.

In his “Sea-Change” speech on the 2nd July, Carney stated “As the perceived probability of a “No-deal” Brexit has picked up, the levels of Bank Rate, Sterling and other UK asset prices in our projections have therefore become increasingly inconsistent with the smooth Brexit assumption in the MPC’s projection”. He then went on to say “The MPC will explore how to best illustrate these sensitivities as we update our projections for the August Inflation Report.”

On the 12th July fellow MPC member Gertjan Vlieghe made a speech on communication improvements. In this speech he said communication is currently:

  • Too complex & inefficient – the BoE have to take a market path of interest rates and reverse engineer policy depending on the inflation outlook coming out of the model.
  • Too inconsistent – we do not get a coherent message on the outlook.

Importantly, he stated that not only would he like to see the preferred path of interest rates published, but also made it clear that under different scenarios “We might still show an alternative forecast based on some other path, in order to show what difference it would make or to discuss salient alternative scenarios, as this would allow outside observers to better understand the MPC’s policy preferences and views of the transmission mechanism”.

I expect no official change in communication at the August meeting as central banks are inherently cautious, even if there was universal agreement on Vlieghe’s recommendations. However, I think it is entirely feasible that in the Quarterly Inflation Report on the 1st August we get more information on the policy reaction to different Brexit outcomes. We might even get a policy path based on a Brexit deal, No-deal or extension period.

Be prepared for more fan charts!

Sign up to receive our weekly BondTalk email

Scream if you want to go higher?

The inflation-linked bond or “linker” market may seem like the slightly strange little cousin to the main gilt market – everyone knows it exists, but mostly ignore until it does something outrageous. At the moment it is screaming!

Over the next two years, the index-linked market is saying that UK inflation (RPI) will average 3.50%. Current predictions from forecasters are that RPI will be in the 2.2% to 3% region in 2019; to get to the 3.5% average that the index-linked market implies over the next two years, RPI would have to reach the extreme heights of c.4.5% in 2020. Given current levels of inflation, and the outlook for currency markets and oil, it seems very unlikely that we’ll get to these levels north of 4% RPI.

So why is the pricing so extreme? The index-linked market is being used as a political hedge against tail risks, and these risks are becoming more and more like the base case for a lot of investors. It all comes down to expectations of where sterling will move from here.

Simply put:

A no-deal Brexit = £ negative + higher inflation.
A Corbyn Labour government = £ negative + higher inflation.
The Bank of England not hiking rates = £ negative + higher inflation.

So investors are buying inflation-linked bonds on the back of their negative views towards sterling. As they rush to buy “linkers”, they meet little resistance in the market – not many people are willing to take the other side of this argument at the moment.

But at today’s level of £/$ at 1.26 (in the post-referendum trading range of £/$ 1.20 to 1.43), you could argue it has done a lot of the work already. How much further are we able to be shocked by UK political events?

At current pricing we think the inflation market should be done screaming here. It should take a little breather.

Sign up to receive our weekly BondTalk email

BoE – a dovish or hawkish rate hike?

The Bank of England (BoE) have today raised interest rates to 0.75%, the highest level in almost 10 years. It would have been a total shock however, if they did not raise the interest rate given the market had it priced in for a number of weeks without any Monetary Policy Committee (MPC) communication of resistance. So on to the next question – was it going to be a dovish or hawkish hike? Well, the answer was it depends on your view on Brexit.

The bank rate is a blunt tool for the MPC and there are a myriad of factors which enter into the collective judgement as to what level of interest rates the economy needs. The largest of all of the factors is without a doubt Brexit, which appears to be the most inscrutable issue to analyse that a Central Bank could ever face. It is not only a standalone factor, it permeates all of the others such as productivity, fiscal constraints, investment, consumer confidence, the level of currency etc.

The BoE also came up with a new way to tie itself in knots – the introduction of the “equilibrium interest rate” (the level of interest rate that would keep the economy in balance – not too hot and not too cold), which in nominal terms is apparently 2-3%. So the question on this is; “How can the BoE confirm the market pricing of another two rate hikes in three years, moving to a 1.25% bank rate, which is so far below their estimate of a neutral rate? The answer; Brexit.

The Governor was quite clear about how important Brexit is, and his guidance to the market appears to be that you need to make your mind up on what kind of Brexit we will get in order to forecast long term yields.

Sign up to receive our weekly BondTalk email

Inflation is bad for bonds – but not in my world

Fixed income. Why bother. It’s a dull asset class that simply involves collecting the fixed coupons and managing relatively stable capital prices. And in an environment of better global growth and the increasing threat of inflation, what’s to like? The value erosion from inflation is bad for bonds, right?

Not so fast…

There is another type of fixed income asset that is linked to inflation – in the UK we call these “linkers”. As the level of inflation rises, the income stream generated by inflation-linked bonds increases – they collect more from the coupons to account for higher inflation.

Sounds good. But what about capital prices – surely these are pretty stable?

Not so much…

Since the start of the year a UK government 50-year linker has been down 10%, up 12% and down 12% again. That is not what I would call a stable capital price! As well as offering inflation protection, there is money to be made (and lost!) from inflation-linked bonds.

I see the benefit of linkers when inflation is rising, but can you make money when inflation falls?

Surprisingly, yes!

If inflation is low and going lower, and let’s say accompanied by a general ‘risk-off’ tone, the long end of fixed income assets can rally (showing an inverse relationship with equities) and within that, bonds linked to inflation can rally too. They are likely to move less than normal bonds, but if they are very long dated (such as that 50-year UK government linker), the duration is so large that the capital upside can be huge.

We can also use derivatives to capture falling inflation – these are called inflation swaps. These instruments are traded “OTC” (over the counter) to make money when inflation falls!

Ok….how does this work?

We enter the swap with a counterparty, agreeing to pay them a floating rate linked to inflation – which we expect to fall. In exchange, they agree to pay us a fixed (constant) rate. On a net basis, if our view about inflation falling is right, we will pay less than we receive over time, and have made a profit from the inflation-linked swap.

To enter the swap contract we also pick the time period we want the swap to last and the country of inflation we want it to be linked to. We can even have positions where we expect inflation to rise in one country and fall in another – a sort of inflation arbitrage trade.

Maybe there’s more to bonds than I thought?


The above demonstrates that some fixed income assets can benefit from rising inflation, are not very stable and not just about clipping a fixed coupon. At Kames as active fixed income managers we understand how to take advantage of the inflation-linked market to the benefit of our clients, a part of the market which is often overlooked by others.

Sign up to receive our weekly BondTalk email

Cure us of this lunacy!

In a remote north-west corner of Scotland there is an island in the middle of a loch called St Maree. On it are the remains of a chapel and a holy tree, believed to be around 1,300 years old. Legend had it that if you rowed around the island twice, submerged yourself in the water and made an offering to the tree, you would cure yourself from lunacy. Many people made this offering over the years, and the tree was filled with hammered-in coins.

Even in today’s more enlightened world, we see versions of this money tree – be it a political party making unfunded promises, or offering money to cure a problem that money can’t solve.

Regarding the latter, central banks globally have offered money to institutions to cure the problem of low or no inflation. They may not directly give the money away (although you could argue that the ECB’s Long-Term Refinancing Operation does just that), but central banks have been buying bonds that institutions hold, both sovereigns and corporates. Through different channels this money was meant to stimulate lending, boost growth and, importantly, lift inflation.

Years on, global GDP looks fine, but inflation has not taken off, while at the same time we have significant side effects – not least inflated asset prices in bond markets.

The ECB is set to continue its QE programme into 2018; yet inflation has not returned to target and is unlikely to over the bank’s three-year horizon. Which leads me to the popular quote: “the definition of insanity is doing the same thing over and over again expecting a different result”.

On the island of St Maree there were too many offerings to the tree – eventually it died of copper poisoning. Is this what we can expect from the central bank money tree?

Sign up to receive our weekly BondTalk email

Prepare to be Prepared

The Bank of England (BoE) today made a not-so-subtle attempt at getting the market ready for an imminent interest rate rise. In the minutes of today’s 7-2 vote it was noted that “a majority of MPC members judge that…. some withdrawal of monetary stimulus is likely to be appropriate over the coming months….”. From previous statements the BoE Chief Economist Andy Haldane has made, the rate rise would be more about removing stimulus added in the wake of the Brexit vote rather than the start of a hiking cycle.

That is the communication tightrope they will have to walk going into the November Quarterly Inflation Report. Do they go down the “one and done” Haldane view? Or do they have the confidence in the economy (and more to the point that wages will finally rise) that means a full-blown rate hiking cycle in the coming months? Of course “coming months” could include February 2018, but either way it is the most explicit the Bank can get in paving the way for a decision.

What should be certain is that we will all be pouring over the MPC members’ speeches in the run up to November. Given that this could be the first increase for 10 years, the Bank will want the market to be fully prepared.

Sign up to receive our weekly BondTalk email

Does the unreliable boyfriend ever want to be Action Man?

The Governor of the Bank of England (BoE) has just said, as it released its Quarterly Inflation Report, that it expects to reduce stimulus more than the market is currently pricing.

Yet the bond market rallies.

The BoE reduced growth and wage expectations for next year, while still predicting above-target inflation three years out, and keeping alive the prospect for a rate hike. One way to square that circle is if it has lowered its assumptions about the potential growth of the economy – meaning that even if we beat trend growth just a little bit, we will be reducing slack in the economy, enough to warrant a reduction in stimulus. In other words, the UK has an even lower bar to beat. This could be seen to be hawkish.

Yet the first reaction of the market was one of scepticism, pushing out rate hike expectations even further. The Monetary Policy Committee (MPC) may now face a communication problem. It has to convince the market that it is serious about raising interest rates, after the hawkish noises heard earlier in the summer were not followed through in today’s vote (as per our earlier article, Haldane could have made it 5-3, yet the vote was 6-2).

Perhaps the best way for the MPC to communicate that it wants the market to price higher interest rates is to actually deliver and reduce the stimulus put in place last August – that will certainly get the market’s attention.

Sign up to receive our weekly BondTalk email

Complain about the winds changing, or adjust the sails?

Following the financial crisis our main central banks (to keep it simple let’s stick with ECB, BoE and the Fed) needed to get real interest rates (the difference between the nominal interest rate minus inflation) down.  This is the normal playbook that a Central Bank should use and even more so after the global financial crisis.  They needed to get money moving again not only to the real economy but also within the financial system which was not only broken but was on the brink of collapse and without too much exaggeration could have brought down capitalism with it.

But the conundrum coming out of the financial crisis was why inflation did not significantly rebound given the spectacular amount of stimulus in place.  As inflation has remained low and even went negative again across the developed world in 2015 the Central Banks kept reducing interest rates and buying bonds – the ECB is still negative and is still increasing the balance sheet to keep these real rates as low as they can without causing too many negative side effects.

The reasons why inflation has been lower than you would have expected will probably become a popular dissertation topic amongst Economic students in the coming years.  I imagine these papers will cover globalisation, online shopping & tech, demographics and the breakdown of the Philips curve to name but a few.  Also I don’t think we should ignore the impact of Shale and the fall in commodity prices over this period.

These are mainly structural changes, but monetary policy is a cyclical tool – and here is the problem. We have policy at what is without doubt emergency levels which has not had the desired effect (apart from one time impacts from falls in the currency) and what it has caused is inflation in asset prices – housing, equities and bonds, not in the real economy and certainly not in wages (which you could argue are structural issues).

Should Central Banks perhaps place more emphasis on growth, employment and wages (which the BoE have explicitly targeted post-Brexit) rather than inflation? Or should that be the job of the Government?  Is that the pertinent question – have our governments collectively failed to adapt to this changing world?

All of which leaves monetary policy in a tricky place.  There are strong arguments coming to the fore that the emergency levels of accommodation should now be removed, not because inflation is becoming rampant, but because perhaps it was an ineffective tool against the structural challenges we face; or maybe Central Banks just need rates to get high enough so that they can cut them again in preparation for the next down turn (confidence is also a tool).  The Fed have raised rates 4 times since December 2015, the ECB will be running out of bonds very soon and there are signs the BoE are becoming twitchy (3 out of 8 voted for a rate hike this week).

For all their failings, at least the Central Banks tried to do something.  They were trying to create an environment where ultra-cheap money could foster growth and self-sustained inflation could flourish. Unfortunately if you were not in those assets that have gone up then all it has done is create greater wealth inequality; and while fiscal spending has been absent it is no wonder that we are starting to see political unrest.  For example, it seems inevitable in the UK that the current government will have to provide their own stimulus to the population, where nothing is off the table, or the people will vote for a party that will.

US inflation – letting off a little steam

The inflation surge as evidenced by the TIPS market (US Government Treasury Inflation Protected Securities) that started around September ’16 has taken a bit of pause and has actually has started to reverse.

Undoubtedly there were some Trump effects to the inflation rally in the US, which in turn lifted markets globally, but the path to higher inflation prints and decent economic conditions was already in place before the November Presidential election. The election just removed some of the downside tail risks.

However, since inauguration day on 20th January 2017, the level of inflation break-evens in the US are now lower. Some of the enthusiasm based on expectations of a relatively quick implementation of tax reform and infrastructure spending, perhaps financed by either Border Taxes or increased borrowing, has fallen away. Healthcare reform has highlighted how difficult it will be for President Trump to implement changes. Another issue for the inflation market is that we may already have reached the high in the US inflation print for this year, 2.7% CPI recorded in February, which does have a psychological impact.

So where does the market go from here?  Expectations are now low for reforms and the medium to long term picture has not changed.  The “America First” policy is still alive but it is proving not to be progressing as fast as the market would like. The fundamentals are solid, core inflation in the US is 2.2% (excluding energy and food) and 5 year inflation is priced at 1.85% according the market, so valuations are compelling.  However, the pause in the market seems correct as we look for the next catalyst.

We are coming to the last seconds of Central Bankers’ 15 mins of fame

The Bank of England has kept its policy rate unchanged at 0.25% and has voted to keep the stock of purchases unchanged by 9-0. This was expected by the market.

The important conundrum for the BoE is if the economy continues to be more resilient than the Banks’ own forecasts, what is its reaction function to above-target inflation?

Within the Quarterly Inflation Report it did indeed improve its outlook for UK GDP. 2017 predictions moved from 1.4% to 2%, coming from both an improvement in household consumption and business investment. At the same time it also moved down its unemployment rate forecast for 2017 from 5.4% to 5%. But it kept its inflation forecast broadly unchanged.

The Bank has managed this by changing its view on how much slack there is still left in the labour market. It does not think wages are picking up fast enough for the level of unemployment that we are at. So it has lowered where it thinks the equilibrium rate of unemployment is – moving this down from 5% to 4.5%.

This gives the Bank of England plenty of room this year to keep interest rates the same even if inflation goes above the target. What will most likely call this into question is if wage growth were to surprise to the upside.

A very interesting throw-away comment from Mr Carney in the press conference: “we are coming to the last seconds of Central Bankers 15 minutes of fame”.

Removing the cover of low inflation

Eurozone CPI has picked up quite dramatically in recent months from 0.5% in October 2016 and just 3 months later to a very respectable 1.8%. Ok, most of this is base effects of energy and food inflation coming through, but the average CPI rate in the Eurozone has only been 1.7% since 2001. At the ECB meeting in December, Draghi managed to extend the current monetary easing QE policy until the end of 2017 when we coming off the back of very low prints. In other words, he had the cover of very low inflation prints to toughen the stance that more monetary stimulus was warranted.

While the 1.8% rate we saw for January is not exactly anything to worry about and the programme will most likely continue in its pre-announced version, Draghi will no doubt play down the inflation prints, stating this is base effects rather than self-sustaining over the medium term. However the disconcerting voices over the QE policy will become louder and I can easily imagine a scenario in the summer months where the “taper” word is being openly discussed.