Because of growing concerns that the energy crisis will increase inflation and trigger further Bank of England rate increases, big investors are betting on a new surge in UK borrowing costs.
The darkening outlook for the £2tn gilt market comes as surging energy prices exacerbate Britain’s cost of living crisis and heighten fears of recession. Goldman Sachs said Monday that UK inflation could rise to 20% by 2023 if gas prices remain high.
Short-term borrowing costs have soared in the gilt market due to bets against UK government bonds. The benchmark for market expectations regarding BoE policy, the two-year gilt yield, was at 3.1% Tuesday, for the first time since 14 years. Bloomberg data shows that it has risen by 1.2 percentage point this month, the highest increase since at most 1992. When prices fall, bond yields rise.
“The UK is in a particularly fragile position,” said one hedge fund manager shorting gilts. The country is “asking foreigners to basically fund” plans for unfunded tax cuts and spending increases “at super low interest rates”, the person added.
BlueBay Asset Management, Odey Asset Management and Transtrend are just a few of the hedge funds betting on rising yields on gilts as investors avoid UK government debt.
Foreign investors ditched £16.6bn worth of gilts in July, the biggest sell-off in the market in four years, according to BoE data released on Tuesday.
“This is only the start,” said Crispin Odey, the founder of the eponymous group. “You’ve got to remember that the [market] consensus is that we’re going to be at less than 3 per cent inflation by the last quarter of next year,” he said, adding that such a forecast was “rubbish”.
Other global bond markets such as the US Treasuries or German Bunds have also seen a sharp decline in recent weeks, as central banks fight inflation.
With inflation running at a 40-year high, the next UK prime minister — due to be announced next week — will inherit an economy under intense pressure, with economists now expecting the UK to slide into recession as the cost of living crisis bites.
Goldman this week forecast that the UK could not escape recession even if Liz Truss, frontrunner to succeed Boris Johnson, reverses national insurance contribution increases and spends a further £30bn on supporting households. The bank now forecasts that the UK’s economy will contract by 1% over the last three months and the second half of 2022.
Ibrahim Quadri, Goldman economist, forecasts that inflation will reach 14.8 per cent by next year. It was 10.1% in July 2022. He warned, however, that inflation could reach 22.4 percent if gas prices remain at their last week high.
UK gas futures hit a high of almost £6.50 a therm last week, but have since eased to about £4.70. They started the year at about £1.70.
The markets are betting that the BoE will raise rates next May to 4.2 percent, up from 1.75 percent at present and 0.1% in November 2021. Investors in debt tend to sell bonds that are due to mature within the next few years when central bank rates rise.
BlueBay’s chief investor officer Mark Dowding believes inflation could peak at 15%. He is shorting gilts. But he compared the BoE to “a rabbit in the headlights” wary of aggressive rate rises for fear of “cratering the UK economy”.
The central bank foretold this month that inflation would reach 13 percent by the end the year, as it predicted that the economy would face a 15-month-long depression.
Funds have been emboldened in their bets because, after buying gilts for more than a decade as part of its quantitative easing programme, the central bank has now switched to selling government debt — a further downward risk to prices.
The central bank bought 57 per cent of the net £1.5tn of gilts sold between March 2009 and June 2022, according to research by Bank of America. Kamal Sharma, analyst at BofA, noted this month that a combination of a large current account deficit and a reliance on overseas investors buying gilts was “significant negative” for the market.
Computer-driven hedge fund managers have also profited of the turmoil in the gilt markets by latching onto trends in global futures market.
Transtrend, a Rotterdam-based firm that manages assets worth $6.1bn, is shorting gilts. These bets suggest that UK bonds will outperform other government-issued debt.
Hedge funds are cautious about the outlook for the gilt market. However, some hedge funds believe that longer-dated bonds are more vulnerable than others because they assume a faster return to lower inflation.
Dowding at BlueBay, which manages $106bn in assets, said he was “perplexed” by the low yields on 10-year bonds, since they imply that inflation will be a relatively shortlived phenomenon. BlueBay is betting on longer-term yields rising relative to shorter-term.
“The yield curve needs to steepen quite dramatically,” he said. Yields on the 10-year gilt “are not compensating me much”.
That view was echoed by Odey, who has been betting against very long-dated gilts such as the 30-year, where he says the market consensus is “most entrenched”.
The yield on 30-year bonds rose from 2.4% to almost 3% this month.
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