On 28 September, the Bank of England’s Financial Policy Committee noted growing risks to the UK’s financial stability, stemming from what it described as “dysfunction” in the gilt market on the back of chancellor Kwasi Kwarteng’s mini-budget.
In the days between the announcement and action being taken by the central bank, yields on government bonds increased sharply, anomalous to pricing trends in other bond markets, and considerably more pronounced than other major repricing events.
According to Invesco, and based on ICE data, the UK corporate bond market fell by around -9% in 2008. In the year to end of September this year, however, the market was down by around -25%. The FTSE 100 was down -4% during the same period.
At this point, the BoE stepped in.
“Given current market conditions, the bank stands ready to purchase conventional gilts with a residual maturity of more than 20 years in the secondary market, initially at a rate of up to £5bn per auction,” it said in a statement, marking the start of an intervention worth up to £65bn.
For investors, the injection of sustained liquidity and reassurance to a stressed market by the BoE signalled an opportunity to review positions within a market already facing significant headwinds.
“In the short-term, the bank’s intervention has been effective. Yields at the long end of the gilt curve, where the purchase programme is focused, have fallen back,” says Lewis Aubrey-Johnson, head of fixed income products at Invesco.
At the start of the week, the 30-year yield stood at 3.8% but rose above 5% on Wednesday morning on the back of “reassurance” provided by the bank’s actions, data from MarketWatch shows.
The relief among investors was “palpable” as the market for sterling assets stabilised, says Dan Kemp (pictured), global chief investment officer at Morningstar Investment Management
Kwarteng’s mini-budget set markets into a “disorderly” pattern, but moods settled and confidence rose as sterling rebounded and bond yields fell.
“Despite the recovery in asset prices, they remain below the prices at which they were trading earlier in September,” Kemp adds.
At the start of September, the two-, five-, 10- and 30-year gilt yields were 3.0%, 2.8%, 2.8% and 3.1%, respectively.
By the end of the month, they were 4.2%, 4.4%, 4.1% and 3.8%, according to Bloomberg data.
“The wider context is a gilt market which is still weak and highly volatile,” says Aubrey-Johnson.
But outside of the gilt bubble, multi-asset investors looked on with muted confidence.
“The moves really haven’t been that dramatic,” according to Salim Jaffar, investment analyst at 7IM, with the impact of the gilt buying announcement resulting in a “round trip” for UK equities and the pound.
“We keep our exposure to gilts low – 1% in a balanced risk profile – so haven’t really felt this pain,” he says.
Reacting to reaction
In the wake of the BoE’s intervention, portfolio managers’ attention quickly turned to decisions on duration.
“Across our funds, we typically started the year short, but have been getting longer,” says Invesco’s Aubrey-Johnson.
Meanwhile, market-wide durations, due to the impact of higher yields, have been declining.
Within Invesco, questions were asked about whether durations should be cut, or whether a high-risk approach may result in stronger long-term positioning, Aubrey-Johnson says. Those on the more conservative side of the fence argue that the “facts on the ground have changed” leaving a “big question mark hanging over the UK.”
By contrast, opportunists looked to yields at 13-year highs as an opportunity to capitalise. In the end, a moderate approach won out. “We think ‘neutral’ is the right place for now,” Aubrey Johnson says. “Cutting back on duration risk here after such a big repricing does not feel right. By contrast, adding risk aggressively here feels like a move more in hope than conviction.”
Looking ahead, fund managers are waiting for signs of more market stability, with it being “too early” to make “big moves”, 7IM’s Jaffar says. Other financial organisations and markets at large are reacting in a similar way.
“Predicting rate moves is hard for anyone especially when everything is moving at 100 miles an hour. Waiting for a bit more stability in rates market seems pretty sensible,” Jaffar adds, noting that the impact of rates and quantitative easing “varies massively” from organisation to organisation.
For now, moods seem to have settled, yet a seemingly endless array of factors threaten to further shape the direction of travel.
The chancellor performed another U-turn on Monday, revoking a period of apparent confidence in the UK market after journalists inside Downing Street were told Kwarteng’s medium-term fiscal plan would come “shortly”, alongside OBR forecasts. The pound hit a two-week high on the news.
“Shortly”, it emerged, is the original date – 23 November – pencilled in for the announcement, leaving markets without a crucial assurance at a pivotal time.
While the BoE’s remedy continues to take effect, markets are awaiting greater fiscal clarity, with investors poised to tolerate increased risk.
As Invesco’s Aubrey-Johnson says: “If we can get just a whiff that UK fiscal policymaking is on a more credible path, then a move higher in duration is on the cards because high rates are now priced in.”