The U.K., The U.S., Inflation & Real Yields

The U.K., The U.S., Inflation & Real Yields

The Bank of England stepped into the bond market, agreeing to purchase Government long bonds until October 14th. The BoE plans to restart its Government bond sale program on October 31st (the central bank plans to sell GBP 80 billion of bonds each year as part of its tightening process).

How did the U.K. find itself in this mess? Years of fiscal spending over and above what was available on its balance sheet (the U.S. does the same). Years of accomodative monetary policy. Ultimately when the money supply grows at a substantially faster pace than production growth (Real GDP), inflation is the outcome. Recently investors have become concerned that new U.K. Prime Minister Liz Truss’ supply-side plans will exacerbate inflation. As a result, investors started dumping U.K. bonds at an accelerated rate.

Wouldn’t the U.K.’s bond market self-correct? Normally it would. As bond yields move higher, certain investors would become buyers in the pursuit of yield, all else held equal. The problem is all else is not equal. The U.S. has seen peak headline inflation (if energy costs do not not spike higher), whereas inflation is climbing higher in the U.K. In addition:

  • Negative Real Yields. As the Federal Reserve pushes rates higher, the U.S. Government bond market is closer to a real yield environment (real yields are when market yields are higher than the prevailing headline CPI), as compared to the U.K. Government bond market. The BoE has its policy rate at 2.25% with approximately 10% inflation, thus real yields are approximately negative 7.75%. Compare that to the U.S. where the policy rate range is 3.00-3.25% while inflation sits at approximately 8.30%, meaning real yields are approximately negative 5.00-5.25% and therefore closer to a positive real yield environment than is the U.K.
  • High Yield Index is in positive real yield territory: The ICE BofA High Yield Index is in positive real yield territory with the index at approximately 9.33%. If the U.S. gets to a point were Government bonds offer a real yield, then the U.K. bond market will really crash no matter how much the Bank of England may fight it as local fixed income investment capital would flee the U.K. in favor of the U.S. Similarly, there would be a massive rotation out of Equities into Fixed Income here in the U.S. The intermediate step of course would be the moment when a majority of Investment Grade corporate bonds find themselves in positive real yield territory which would pull capital out of Equities.

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