UK bond yields are too low, further rises likely soon

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●  Gilt yields – the rise has only just started: After reaching record lows across the curve in July 2020, UK benchmark rates started to rise sharply at the start of the year. Ten-year gilt yields rebounded from 0.15% on 2 January to 0.75% by early March. Despite further upward pressure from economic fundamentals, rates have moved mostly sideways since then and remain at near pre-pandemic lows. Four reasons point to further upward moves soon.    Â

1) Slowing BoE purchases: The BoE started to taper its asset purchases in the week beginning 10 May. While the reduction in asset purchases from £17.6bn per month to £13.6bn remains modest, we expect the BoE to announce a further cut to c£6.8bn on 5 August before the current envelope is completed by year-end.

2) Net issuance remains high: The UK government has borrowed heavily from markets to fund its massive emergency healthcare and economic policy response to the pandemic. While monthly net-issuance of gilts has dropped sharply from the £62.5bn peak in May 2020, it remained high by historical standards at £23bn per month in February and March (five-year monthly average to December 2019 was £3.8bn). From February 2020 to April 2021 the BoE gobbled up c92% of the increase in public sector debt. All else equal, the laws of demand and supply dictate that gilt yields will rise in coming months once the rate of new debt creation exceeds the rate at which the BoE purchases such paper. This may become a major contributor to rising yields once BoE net-purchases end.Â

3) Confidence is improving: Household, business and market sentiment has surged since the start of the year. Consumers’ expectations for the general situation in 12 months reached a six-year high in May, according to GfK, while the May composite PMI hit a record high. UK domestic equities have rebounded sharply since mid-2020 – the forward P/E on the FTSE 350 remains at its highest since 1994. Over time, strong confidence should reduce precautionary demand for safe assets such as gilts and increase the rates at which the UK government can borrow.Â

4) Inflation expectations are rising: Retail price index (RPI)-based five-year breakeven rates have risen from a low of 2.4% in April 2020 to a post-Lehman high of nearly 3.5% and are rising on trend. The current breakeven rate of 3.5% equates to a c2.7% inflation rate based on the consumer price index (CPI) – well above the BoE’s 2% target.

●  Here today, gone tomorrow? Given such developments, it is somewhat surprising that bond yields have not yet risen further. It may indicate that the market consensus, much like major central banks, does not expect the current period of strong growth and rising inflation to last beyond the recovery phase of the business cycle. Of course, only time will tell. However, we think there is good reason to believe that the ongoing strong cyclical upturn in the UK and across the advanced world will turn into a sustained recovery with real growth above the pre-Lehman trend and core inflation that averages 2.5% by the middle of the decade. This justifies higher benchmark rates, in our view.

●  Outlook for rates: Further upside surprises for key economic data such as GDP and underlying prices should raise benchmark yields in coming months – we forecast 10-year gilt yields at 1.5% by end-2021. Thereafter, further rises are likely during 2022 – see chart – as the BoE reacts to upside inflation risks by outlining its exit strategy in early 2022 before hiking rates for the first in August 2022 – see BoE likely to start normalising policy in 2022 (24 May 2021).

● Conference call: We would like to invite investors to a call on 27 May to discuss these issues alongside our broader UK strategy and views on UK banks. To register, please contact Berenberg’s sales team or Eleni Papoula, our financials specialist salesperson (eleni.papoula@berenberg.com).

Kallum Pickering

Senior Economist

+44 20 3465 2672

kallum.pickering@berenberg.com

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