RBC BlueBay: Gilt yields speed past ‘Nutbush City Limits’

May 26, 2023

Notwithstanding the ongoing stalemate with respect to the US debt ceiling, rhetoric playing down the risk of a debt default has helped to mitigate fears of a left-tailed risk impacting global financial markets.

Although there is scope for fears to flare up as the X date (when the Treasury is out of cash) approaches, for now attention has switched back towards underlying economic fundamentals and the projected path of monetary policy.

This being the case, data continues to suggest that there is reasonable momentum in the US economy. Although survey data has hinted towards a weakening in the trend of activity, hard data suggests that demand continues to hold up relatively well for now. In this context, earlier fears that the hiatus in US regional banks would bring about an abrupt credit crunch appear to be fading.

Meanwhile, although progress on bringing inflation down is anticipated, there is a sense that a 2% target is a long way away, and that the Fed may not yet be done with the process of pushing rates higher.

Several Fed members have recently made comments supporting a June hike, and although the fate of the FOMC will hinge on key payrolls and inflation data, it seems like the odds on further policy tightening are finely balanced.

Moreover, the notion of early interest rate cuts continues to be priced out. Consequently, Treasury yields have moved higher over the past week, with this move being led by the front end of the yield curve. In this context, two-year yields are now up by 45bp over the past month.

In hindsight, it seems that the curve had become too inverted during the course of the spring. With cash rates north of 5%, so a bullish view on front end yields required either a very bullish assessment on inflation falling, or a very bearish assessment on growth. In the event, it seems neither has been forthcoming.

That said, we continue to see US rates as fair value, broadly speaking. 10-year yields are close to levels seen at the start of the year, and we have thought that 2023 could represent more of a range trading environment for US yields.

European yields have also moved higher over the course of the past week. ECB rhetoric remains relatively hawkish for now, and we continue to expect the central banks to hike by 25bp at each of its next two policy meetings, in line with market projections.

Thereafter, we think we will need to evaluate data and it will be interesting to see how quickly that policy restraint can bring inflation under control.

Meanwhile, Greek elections saw a strong performance for New Democracy. The Greek economy continues to perform relatively well, and the approach to policy orthodoxy being pursued is helping to push government debt levels lower. Further credit rating upgrades for Greece remain likely.

However, the bond market remains relatively illiquid and now offers materially less in terms of spread compared to a peer like Italy. From that point of view, we don’t see much value in GGBs, but this is not a comment on the politics.

Relative value is a bigger consideration and within the EU, we see most value coming from sovereign credits such as Romania, whose debt level is a fraction of that prevailing in either Italy or Greece, but where long-dated debt offers twice the amount of spread to investors.

UK yields have been in the spotlight over the past week or so, with 10-year rates jumping by around 65bps so far this month. Gilts have been materially underperforming their peers this month, with long-dated yields back to levels seen last autumn under the Truss government. Part of this move has been in sympathy with global yields.

However, it seems that the penny is starting to drop with respect to UK inflation. Although this week’s data saw a drop in CPI on base effects, core inflation rose to a 30-year high at 6.8%. It seems likely to us that UK inflation will stay stuck at much higher levels than in other developed economies, and this will push a reluctant Bank of England to continue to hike rates.

Meanwhile, the UK deficit means that there is ongoing heavy issuance of gilts all year. Recently, there has been a sense that demand for gilts has been dropping. Indeed, we have previously noted the negative convexity in UK yields, which means the demand for duration falls as yields rise, and those hedging long dated duration liabilities need to own less.

With the gilt market dependent on institutional demand, so this runs the risk of gilt underperformance extending, as the government needs to continue to finance itself. A weaker economy won’t help the deficit at all and with the UK having lost its safe-haven status, it is not clear that overseas investors will be rushing to the rescue soon.

With pressure on Sunak and his cabinet to award elevated pay rises to health sector workers, as well as others in the public sector, so the government may find that it has limited room for manoeuvre. After a honeymoon in the wake of the departure of Truss, so the Sunak government may need to do more to woo the gilt market, but this may imply difficult decisions which won’t sit well with voters.

In credit markets, IG spreads have performed better over the past week, following a difficult first half of the month. Nevertheless, credit has lagged the performance of equities over the past several weeks and there is a sense that investor positioning remains relatively cautious, anticipating slower growth and potential recession risk later this year.

In emerging markets, we have witnessed a quieter week following volatility in Turkey and South Africa the week before. Events in Ukraine continue to have relatively little market significance for now, but on a geopolitical level, the direction of travel within the G7 is towards a more multi-polar world. This is a factor which can weigh on prospects for China, and those reliant on Chinese demand, over the medium term.

Meanwhile, FX was relatively quiet over the past week. The yen has been underperforming as the BoJ drags its heels on policy normalisation, even as other global central banks continue to push a more hawkish agenda.

However, we think there is a good chance that the BoJ will be pushed to revise its 2023 inflation projections very soon. In light of this, a policy shift could trigger weakness in JGBs, while also helping the yen to rebound.

Elsewhere, it was also notable that unlike the period last autumn when UK gilt yields spiked higher, this time around there has been no accompanying sell off in the pound. That said, we think that further UK underperformance could lead to renewed financial stability fears and we continue to look for the pound to end up having to bear the strain.

Looking ahead

Data towards the end of next week may be significant for shaping the outlook during the course of June. With Fed policy finely balanced, we think that data in the next few days will carry a disproportionately high weight in determining the path of policy action.

This in turn may also lead market direction. With headlines surrounding the debt ceiling also likely to keep coming, we have thought that volatility could pick up in the next couple of weeks, and so reducing directional risk has merit in our eyes.

We still think a compelling opportunity to generate returns can come from markets overshooting in either direction, and so although 2023 has proved somewhat frustrating so far, we think we are well advised to remain patient and wait for a clearer opportunity to come our way. 

In the words of the late great Tina Turner, who sadly died this week, we find ourselves waiting for the “Steamy Windows” to clear. Meanwhile, with gilt yields breaking into new ground, it feels like yields have raced through ‘Nutbush City Limits’ and are in clear air.

It is possible that an overshoot towards 5% on 10-year rates may represent the sort of overshoot in markets we are looking for. However, for the time being, we remain structurally cautious on the UK and think that the pound will be the next shoe to drop, and the most obvious trade at this particular point in time.