No, current gilt yields don’t vindicate Liz Truss, please don’t make us explain this again

The price of Liz Truss is eternal vigilance.

Here in the UK, the economy is not going super good and many of the numbers are not how one might want them to be. As other major Western economies prepare for the end of rate hikes or try out pointlessly gentle recessions, Britain is still stuck in the active fight against inflation.

A corollary of this is higher yields on UK government debt. Earlier this week, the yield on sensitive two-year gilts pushed to the highest since 2008 — significantly (or not!), higher than during the LDI/Trussterflux/“Fiscal Event” that wracked and wrecked UK markets last autumn and led to Truss’s ignominious defenestration from high office.

A certain group of people have been extremely 🤔 about this, making sage comments along the lines of “Oh interesting, so will we be sacking Rishi Sunak then?”.

Many of those people are either confused, wilfully ignorant or disingenuous. Some of them have newspaper columns.

We don’t want to feed the trolls, and we already covered Liz Truss’s My Part In My Downfall (and associated coup conspiracy theories). But given people without newspaper columns might reasonably be questioning why things are different now, here are some attempted answers.

Moron Risk Premium is not as elevated

One important reason why September 2022 yield peaks can’t be compared with those in June 2023 is because they were in September 2022 and it is now June 2023.

A key concept in global markets is relativity: for an investor who has already decided they want to buy some government bonds, the price/yield on gilts matters less in absolute terms than in terms of how it compares with the alternatives.

This is why, when we attempted to calculate the UK’s “Moron Risk Premium” — ie the extra yield the government was forced to pay lenders because Truss was seen as a liability — we used spreads, specifically over German Bunds, as a metric. That way, you see how yield has moved relative to a competitive asset.

This is as good a time as any to note that yield on 30-year gilts — which were the bonds at the centre of the LDI crisis, not 2-years — are not quite back at those Truss-y heights:

They’re pretty close nonetheless. But looking at them in terms of spreads over Bunds (which are more comparable that US Treasuries due to relative economic strength), there’s still a long way to go:

It’s not pretty, but it’s nowhere near as bad as it was in September. Applying our Moron Risk Premium formula ([gilt yield]–[Bund yield]—[1pp of baked-in UK risk premium]) and then multiplying it by the Office for Budget Responsibility’s ready reckoner figures on how much an extra percentage point of yields costs in cash terms, we can see there’s still a decent bit of what we later dubbed “toastal nation premium” about:

What’s less clear from that is how much of the Moron Risk Premium underpinning those additional costs is now from the Government’s behaviour, versus, say, the UK’s worryingly sticky inflation.

Speed matters

As we mentioned in our Trussay analysis, the thesis that the Bank of England was responsible for the LDI crisis — by initiating quantitative tightening at a time when the government was ramping up borrowing, thus flooding the gilt market — relies on not being able to read a chart.

Specifically, the shock moves of the crisis were spurred, as the intraday data shows, by the things that Truss and rapidly-dumped chancellor Kwasi Kwarteng were doing and saying, like introducing policies with limitless costs, teasing uncosted tax cuts, and sacking senior civil servants.

Rates rose rapidly as a result, and it was this speed that caused such issues for LDI scheme providers (who would benefit in theory from higher yields).

How rapidly? Well, this is how much 30-year yields rose, open to peak, over three days during the LDI crisis, versus how much they have risen over the 161 non-weekend days since Sunak became prime minister:

The domestic macro environment has shifted

Relativity doesn’t just matter in terms of bonds. The most fundamental factor underpinning gilt yields is UK interest rates, as set by the Bank of England.

As Barclays FX strategist Lefteris Farmarkis put it in a note this morning:

The sharp repricing higher in UK rates in the wake of solid labour market data has evoked memories of the rates sell-off last September, along with a question regarding sterling’s reaction. Indeed, BOE policy expectations are now close to what seemed lofty heights at the peak of the LDI crisis, albeit from a much higher starting point in Bank Rate. Interest rates across the curve are also hovering around the September 2022 highs. 

Appearances to the contrary, however, the dynamics of the current interest rate adjustment are very different. This is because this week’s move has been driven exclusively by a shift in policy rate expectations, in stark contrast to last September, when the shift in policy expectations was accompanied by a sharp rise in term premia.

Here’s how those shifting expectations look:

A useful measure here would be to view the expected terminal rate as a time series and spread that against yields, but the peak is a moving target so that’s not easily done (if it is, please let us know). Still, even looking at the appreciation of the bank rate versus eg 10-year yields since the hiking cycle began in late 2021 shows how much of an outlier last September was:

The other macro factor is the mighty mighty pound, with has a total return of about 7 per cent so far this year — the best of the G10 currency group, and third-best among Majors.

For reasons that are semi-understandable (gilts nearly caused a financial crisis, the pound didn’t), sterling’s fall to an all-time low against the dollar during the LDI debacle is often ignored.

Yes, sterling’s recent strength is intertwined with a relative strengthening in gilts, as international demand for gilts pushes up demand for pounds. But even if it was treading water it would present a marked contrast to the almighty efforts to dump UK assets that Truss triggered.

Aggressive policy expectation and sticky inflation make sterling an attractive carry trade, but Farmarkis thinks Brexit is going to put a cap on how far the pound can rally:

A more fundamental limitation to sizeable upside, especially versus the EUR, relates to the very tight post-Brexit range within which the pound has been trading. In our view, this reflects sizeable Brexit premia, which are likely to stay elevated over the medium term.

The outlook is still uncertain

Deutsche Bank put out an interesting chart earlier this week, showing how the Bank of England has struggled to close the gap between current interest rates and market expectations of the terminal rate:

Deutsche’s Shreyas Gopal and Sanjay Raja wrote:

[The] market had assessed the BoE to be inching in the right direction, with the distance between the policy rate and the terminal rate priced by the market falling from September to March. Much of that hard work has been washed away of late though, with pricing suggesting that the UK is just as far away from its landing zone as it was late last year.

By comparison, the European Central Bank and US Federal Reserve look almost done. After today, WIRP pricing suggests the ECB might have one hike left, while mixed signals from Jay and the gang have left open the possibility that the skip will become a pivot.

And there’s still plenty of potential for danger in future UK CPI readings: in the aftermath of peak pandemic (complicated, no doubt, by the far higher volatility of inflation), economists have simply become worse at guessing how prices are changing, tending towards underestimation:

Higher interest rates are being looked at largely as an unvarnished evil in the UK media, which is unfair. Here, from the Telegraph, is an example of how the politics are playing out:

The Prime Minister’s spokesman told banks to look after customers who were struggling with the jump in costs. 

He said: “The Chancellor has made clear his expectation that lenders should live up to their responsibilities and support any mortgage borrowers who are finding it tough right now.”

The spokesman added: “There do remain a large range of mortgage deals available to the public, but we know this current situation may be concerning for some homeowners and mortgage holders.”

To which the response for a lot of UK renters has broadly been (justifiably for many): 🎻👌

So does a mortgage crisis loom? Not in the near term, reckons Pantheon Macroeconomics’ Samuel Tombs:

[While] new mortgage rates will rise further over the coming months, only about 7 per cent of all fixed-rate mortgages will be refinanced in Q3 and Q4, and only 30 per cent of households have a mortgage

The pain, instead, will be steady and come over several years. It all adds up to conditions under which the UK could be facing, at least, continued stagflation, or possibly inflation and a light recession. Which is:

— more or less what’s clearly been on the cards for the past year and a half
— obviously shit
— not at all comparable with Truss nearly crashing the economy

Got it?