British Bonds Teach a Lesson on Political Bias

Last autumn, 10-year UK gilt yields spiked over 4.5%, triggering a fallout among some pensions and the downfall of former Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng, whose “pro-growth” agenda of very modest tax cuts got the blame for bond market carnage. Yields fell, replacement Prime Minister Rishi Sunak and Chancellor Jeremy Hunt won global accolades for trying to rein in the deficit, and everyone went on with life. So much so that now, with 10-year gilt yields now back above their October 2022 high, it gets little notice globally and virtually no one is calling for the government’s ouster. We see a couple of timeless investment lessons here.

First, high interest rates alone didn’t cause last autumn’s pension dust-up. Back then, when long-term rates rose, it created a pickle for pension funds using a tactic called liability driven investments (LDI). We have a more detailed synopsis here for those who would like a full refresh, but this is a tool UK funds use to (ideally) match long-term returns to long-term liabilities, and it involves using leverage. When long rates rose and gilt prices fell, several funds got hit with margin calls. To meet them, they turned to the easiest, most liquid source of cash: selling gilts. These forced sales further hit bonds, which forced more sales until the Bank of England stepped in with emergency pension funding and bond-buying programs. These helped bridge the gap until markets calmed, leaving a national debate about LDI and pension regulations in their wake. This culminated in new guidance, issued this April, mandating stress tests and higher liquidity buffers.

Those buffers may be one reason 10-year yields trip back north of 4.5% hasn’t triggered a fresh crisis—if not because of the new guidance, then because several funds proactively built larger cushions once last autumn’s fracas died down. We suspect gilt yields’ slower rise this time also plays a role. Exhibit 1 shows the 10-year yield’s movement over the past year. Where last autumn’s jump was a twin spike, the latest ascent has been more gradual, giving funds time to adjust their portfolios as needed to prevent margin calls. Usually, it is markets’ rate of change, rather than their direction or cumulative move, that catches traders and fund managers off guard. This is why there is no set level of interest rates (or any other market) that is inherently problematic. Time is a friend.

Exhibit 1: A Year in the Life of 10-Year Gilt Yields

Source: FactSet, as of 7/10/2023. 10-year UK gilt yield, 7/7/2022 – 7/7/2023.

Which brings us to Lesson Two: No political leader or policy suite has a pre-set market impact. When yields fell as Sunak and Hunt took office, headlines took it as a foregone conclusion that this was a big market vote of confidence in the new leadership. Abandoning a very modest tax cut agenda was supposedly the right thing to do: Fiscal probity would tame inflation and lower interest rates would work hand in hand with lower deficits to restore the world’s confidence in the UK.

Sunak and Hunt fulfilled those “austerity” predictions with continued stealth tax hikes and some investment tax increases at this year’s Budget. We put austerity in scare quotes because this Budget—like former Chancellor George Osborne’s past austerity budgets—preserved spending increases. However, it was the antithesis of Trussonomics’ focus on unleashing investment and the private sector by putting more money back in the people’s hands. But inflation has been more stubborn than many anticipated, pumping long rates back up and teeing up higher household bills as mortgage payments reset at higher rates. In other words, the very thing the proverbial grey-suited types were trying to stave off when they ran out Truss and Kwarteng. Turns out the Bank of England’s rate hikes and global market factors were a much bigger influence on UK long rates than local political factors and deficit chatter.

In our view, this is a shining counterpoint against the widespread, perpetual temptation to presume Politician X will have Y effect on markets. Those presumptions are virtually always based on political biases, which are widely known and therefore pre-priced. Markets are excellent at doing what the crowd doesn’t expect. Acknowledging this tendency is a key part of navigating political developments correctly.

Now for some parting good news: With inflationary forces easing and central banks globally much closer to the end of their tightening cycles than the beginning, the upward pressure on long rates in the US, UK and Europe looks likely to wane. This isn’t a direct stock market driver contrary to what many seemingly argue these days. But in the UK at least it should help salve some of the concerns that have weighed on sentiment during the correction UK stocks have endured in price terms (when measured in pounds) since their last high in mid-February. Turning points are impossible to predict or identify in real time, but as false fears gradually fade UK stocks should resume their climb up the proverbial wall of worry—with tailwinds from positive forces globally.