The new UK government’s policies are likely to mean that inflation and bond yields remain slightly higher than many investors expect, impacting the bond market, according to Lloyd Harris, head of fixed income at Premier Miton.
Harris said: “We think that Starmer’s plan for growth in the UK will be tested by the gilt market. With full employment in the UK, the only way to grow is to increase wages, unless there are new entrants into the labour market through either increased immigration or greater necessity to work. With both these options off the table, the only outlet can be wage growth, which will keep services inflation sticky.”
He added: "We think investors should look to Labour’s “new deal for working people” for the future path of inflation. With the UK being primarily a services-based economy, wage costs are a major input into the path of inflation and hence future interest rates and bond yields.”
In terms of what that means for the gilt market, Harris view is that the longer dated bonds are relatively less attractive than the shorter-dated bonds, as longer-dated bonds tend to perform best when inflation expectations are lower.
As many market participants expect UK interest rates to be cut from here, longer-dated gilt yields have fallen.
As the price and yield of a bond more inversely, if the yield on a bond is falling, the price is rising.
Supply and demand
Andrew Hunt, an economics consultant, says the level of government bond issuance in the UK in recent years has been high, and that regardless of which party won the election it will continue to be high as the country runs a budget deficit.
In a note to clients he says that a significant portion of the buyers of gilts are overseas investors, and says that the gilt market could face a crisis, as demand dwindles relative to supply, unless action is taken.
A previous example of the action being taken was the Bank of England’s quantitative easing programme which bought gilts, ensuring a level of demand for the assets within the economy.
That programme is now being wound down, removing a significant buyer from the market, at a time when the supply of gilts, that is, the quantity of new gilts being issued by the government, is not falling.
The supply/demand imbalance will, says Hunt, have to be filled either by overseas buyers, or via recessionary conditions in the UK.
Recessionary conditions in the UK may boost demand for gilts from domestic investors as a they seek a “safe haven” and move away from riskier assets such as equities or corporate bonds.
Hunt says that while UK economic activity has returned to something closer to what many market participants regard as “normal, normal is not sustainable” as productivity has been weak, with the consequence that wage growth has been weak.
But he says despite this, consumer spending has been high for many years, particularly on imported goods, creating a scenario where inflation rose, but also why the UK’s current account deficit has been weak.
