Financial trends: gilts viewed once again through a macro lens

Gilts are named after the gilded edge of old-time UK government debt certificates. This signified the highest credit. That status was put to the test earlier this year by the short, chaotic premiership of Liz Truss. Yields soared after her ill-judged spending plan triggered intervention by the Bank of England to prevent a bond market meltdown.

The appointment of Rishi “Safe Hands” Sunak as prime minister has all but removed the fiscal risk premium gilts bore back then. The outlook for gilts is now more likely to be decided by genuine macroeconomic factors than “unconventional” economics.

Measured by the spread of 10-year gilts over German Bunds the risk premium peaked at 225 basis points in late September 2022. It has since fallen back 100bp. That leaves it a little higher than the average for the past two years. Inflation, real and expected, is likely to resume a bigger role in driving yields hereon.

Expect a weakening economy to take much of the heat out of spiralling prices. These rose on average by 9 per cent during 2022. With interest rates already at the highest level in more than a decade, slowing growth should drag prices lower. The consensus among economists is for average real GDP growth of -0.9 per cent next year with inflation falling to 6 per cent.

That is taking pressure off the BoE to raise further. Policy rate expectations have slipped from more than 6 per cent during the height of the pension crisis to an expected peak of 4.7 per cent at the end of 2023. Tighter fiscal conditions, with about half of a £50bn budget hole to be plugged by tax rises, will dampen inflationary forces further.

In the best of all possible worlds that should mean bond yields will continue to fall. Risks linger. A wage-price spiral could continue to drive yields higher even as the economy weakens. Further shocks to supply cannot be ruled out. But at least the UK’s creditworthiness has regained some of its old glitter.