IF YOU blinked you may have missed it, but a few weeks ago gilts took a hammering; the yield on the ten-year bond kicked up close to 2.5 per cent. That was a big move, enough to have rattled some cages.
It has since eased back; anyone woken by the rattles may be nodding off again by now. But was this just a flurry or might it have signalled the start of a trend? And if so, what are the risks to other asset classes?
Some of it is explained by simple mathematics. Forward expectations for the Bank rate have changed – markets’ bet on timing for the first increase from 0.5 per cent have shifted closer by fully two years.
Term yields in the gilt (government bond) market are essentially forward indicators of assumed future interest rates and if those assumptions change, then the yields ought to as well.
If that were all there was to it then you might expect yields to find a new equilibrium just a bit higher than before. This does indeed seem to be the early outcome but still at abnormal extremes it seems more likely that yields have taken their first small step on a journey back to normality.
Given the increase in the quantum of coerced buyers and an assumption that trend growth post-recession is likely to be somewhat lower than it was; somewhere around 3.5 per cent looks a plausible resting place. That’s less extreme than a shift back to the “old normal” of 4.5 per cent or so but it’s a big enough move nonetheless.
The consumer prices index (CPI) measure of inflation is falling nicely. The Bank expects it to fall below the 2 per cent target, although though others reckon oil prices may keep it higher.
Either way, the yield on the ten-year bond is set to become positive again in real terms.
You would think that a positive real yield makes the gilt a much more attractive investment. Life isn’t like that – more likely it will focus participants’ eyes on the longer term macro-economic outlook and the further scope for upward shifts in the entire yield curve, making the bond seem less attractive.
For most investors, the key is whether – rather than when – what will eventually be a substantial shift in the relative valuation of the gilt market will impact adversely other assets. Higher yields translate into increased cost of capital and would normally be taken as negative for risk assets. This time should be different.
The yield may establish itself as positive in real terms but that margin will be under pressure from inflation. An end to China’s contribution to goods price deflation, the reality that spare capacity in the UK economy is much thinner than thought and the risks inherent in ultimately running down the Bank’s quantitative easing mean it does seem reasonable to expect medium term inflation to track above rather than below the target, even at relatively pedestrian rates of growth. In real terms, the gilt isn’t going to offer strong competition.
However, against the odds and despite what I’m now expecting gilts to do, traditional developed equity in global companies with strong franchises and secure cash flows look as good a bet as any. Gilts may be reverting to what they do best: losing investors their shirts. Unusually, though, the collateral damage for other asset classes may be not merely minimal; there may be no damage at all.
There’s always a snag. This sounds like the consensus view, a dangerous place to be. All being well the consensus will crumble but as it does equities may wobble. Bring it on: wobbles equal opportunity for investors with vision. Wobbles are good.
• Peter Bickley is a consultant economist
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Sunday 26 May 2013
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