Big investors are betting on a fresh surge in UK borrowing costs because of mounting concerns the energy crisis will inflame inflation and trigger further Bank of England rate rises.
The darkening outlook for the £2 trillion (€2.33 trillion) gilt market comes as surging energy prices exacerbate Britain’s cost of living crisis and heighten fears of recession. Goldman Sachs on Monday said UK inflation could exceed 20 per cent by the start of 2023 if gas costs remain highly elevated.
The wagers against UK government debt have already sent short-term borrowing costs in the gilt market soaring. The two-year gilt yield, which reflects market expectations for BoE policy, touched 3 per cent on Tuesday for the first time in 14 years. It has jumped 1.2 percentage points this month in the biggest rise since at least 1992, according to Bloomberg data. Bond yields rise when prices fall. Sterling has also taken a hit, falling on Tuesday to as low as $1.1623, the weakest level in more than two years.
“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 said.
Odey Asset Management, BlueBay Asset Management and Transtrend are among the hedge funds betting that yields on gilts will continue rising as investors shun UK government debt.
Foreign investors ditched £16.6 billion 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, including US Treasuries and German Bunds, have also sold off sharply in recent weeks as central banks battle 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, front-runner to succeed Boris Johnson, reverses national insurance contribution increases and spends a further £30 billion on supporting households. The bank now expects UK economic output to contract by 1 per cent from the final three months of this year and the second quarter of 2022.
Goldman economist Ibrahim Quadri forecast that inflation will peak at 14.8 per cent early next year from 10.1 per cent in July 2022. But he warned that if gas prices remain at the levels hit last week, inflation could reach 22.4 per cent.
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.
Markets are now betting the BoE will raise rates to 4.2 per cent next May, up from 1.75 per cent at present, and 0.1 per cent in November 2021. Central bank rate rises tend to lead debt investors to sell off bonds maturing in the next few years.
Mark Dowding, chief investment officer at BlueBay who is shorting gilts, said inflation could peak at 15 per cent. 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 warned this month that inflation would hit 13 per cent by the end of the year as it forecast the economy faced a 15-month-long recession.
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 £1.5 trillion 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 funds that latch on to trends in global futures markets have also seized on the turbulence in the gilt market.
Rotterdam-based Transtrend, which manages $6.1 billion in assets, is shorting gilts and other UK fixed income instruments. Many of these bets are that UK bonds will underperform debt sold by other governments.
While the hedge funds are pessimistic on the overall outlook for the gilt market, some say that longer-dated bonds are particularly vulnerable because their level of yield assumes a fairly rapid return to lower inflation.
Dowding at BlueBay, which manages $106 billion in assets, said he was “perplexed” by the low yields on 10-year bonds, since they imply that inflation will be a relatively short-lived phenomenon. As a result, BlueBay is betting that longer-term yields will rise relative to shorter-term ones.
“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 Mr 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 jumped from 2.4 per cent to almost 3 per cent this month alone. — Copyright The Financial Times Limited 2022
