One week / one topic: Notes from a small island

What happened?

UK government bond yields have been rising visibly as of late, once again capturing investors’ attention.

Beyond the appeal of round numbers – 30yr yields printed 5% once again – the UK also gets more than its fair share of attention as London remains a major financial center, potentially increasing the chances for self-fulfilling prophecies.

Additionally, investors’ confidence never really fully recovered from the ‘Liz Truss shock’ of 2022 – and for the third year in a row, autumn brought increases in yields as investors keep displaying varying degrees of skepticism towards the government’s fiscal plans.

The recent admission that campaign promises of ‘no need for higher taxes’ were wrong certainly didn’t help, and neither did the fact that the most recent budget announcements leave a very thin margin vs any increase in borrowing costs.

Almost regardless of who is saying what, markets remain wary of British government officials.

Timeo Britones et dona ferentes…

With markets already focused on such a fragile situation, the UK's tax burden rising to a post-war high of 37.7 per cent of GDP is clearly a further cause for concern.

What to make then of such developments? Are UK Gilts an attractively-priced asset at these levels, or is it better to steer clear?

Our observations

• Fundamentals: While real rates have convincingly reverted to positive territory and the inflation outlook remains uncertain, the UK remains a G7 money-printing sovereign with its own independent monetary policy – the 2022 fiasco should then (hopefully) remain a one-off.

• Price action: 30-year yields at 5% are certainly noteworthy, yet the best cure for high interest rates might well be… high interest rates. Stay tuned for further developments.

• Investor beliefs: The Pavlovian conditioning of the Liz Truss ‘mini budget’ is certainly understandable, but investors – despite lingering structural concerns – should probably move on and not expect such fireworks around every UK budget announcement.

So what?

As we look to increase duration across portfolios while also adding to our equities position, a diversified approach to our holdings of government bonds seems the most prudent course of action.

Consequently, long-dated UK Gilts look appealing as an additional source of attractively-priced portfolio insurance on top of our positions at the long end of the US curve.

Meanwhile, equity-bond correlation looks tentatively less firmly rooted in positive territory, giving investors hope that diversification is indeed ‘back’ now that inflation is not an emergency anymore.