Inflation fears push UK bond market towards crisis levels again
[LONDON] Britain is bracing itself for the fallout from a sharp rise in both short-term and long-term interest rates.
There have been renewed worries over the past week about the UK bond market due to the country’s stubbornly high inflation, with the 10-year bond hitting a yield of 4.3 per cent – almost at the level that sparked a crisis last autumn during the troubled premiership of Liz Truss and her disastrous mini-Budget.
Britain’s inflation rate fell by less than expected to 8.7 per cent in April, down from 10.1 per cent in the month before, although it still meant the UK has the joint highest rate of inflation among the Group of Seven advanced economies.
Last October, local and foreign investors – spooked by Truss’ failed mini-Budget that included the biggest tax cuts since 1972 – dumped UK government bonds to an extent that scores of pension funds were facing collapse, forcing the Bank of England (BOE) to intervene.
After Truss resigned, there was a rally in the following months as investors hoped that her successor, Rishi Sunak, and Chancellor of the Exchequer Jeremy Hunt would reduce the budget deficit and bring about economic growth with lower inflation.
However, the persistently high inflation levels have caused investors and holders of UK gilts (sovereign bonds) to become jittery.
Bond traders and analysts predict that the 10-year yields could increase to more than 5 per cent unless inflation declines considerably. And in nominal and real terms, the yields of 10-year UK gilts are now higher than those of Greece, Italy and Spain.
Luke Hickmore, investment director at abrdn, a fund manager with £376 billion (S$631 billion) under management, said that with the BOE possibly raising rates from the current 4.5 per cent to 5.5 per cent, it is “highly likely” that Britain will enter a recession towards the end of the year.
Markets have been “pretty tumultuous” because of disenchantment with the UK’s inflation numbers, said Hickmore in a recent radio interview.
Some bond traders said that rising gilt yields will cause mortgage rates to go up and place more pressure on people who are already squeezed by food inflation of 19 per cent.
Higher rates are already having an impact on homeowners and property affordability, with demand and rental costs surging.
The BOE and the Office of National Statistics estimate that more than two million mortgages, which were on rates of around 2 per cent, will be renewed in the 12-month period ending November 2023. The current mortgage rate on two-year deals is already at 5.35 per cent, and it is inevitable that these households will feel the financial strain, said analysts.
Both Hunt and BOE governor Andrew Bailey sought to present themselves as competent economic managers after the chaos of Truss’ brief stint at 10 Downing Street, but they have struggled to do so in the face of rampant inflation and stagnant productivity levels.
Some hawkish former BOE rate-setters have suggested that interest rates will need to reach as high as 6 per cent to stamp out inflation, a level that the central bank has described as “painful” for households and businesses.
Asked recently on Sky News if he was comfortable with the central bank’s rate hikes, Hunt replied: “Yes, because in the end, inflation is a source of instability.”
He added that he “had to make difficult decisions to balance the books”, so fiscal and monetary policies needed to be aligned.
The government’s interest bill on its £2.5 trillion debt is also expected to be higher than the previous budget estimate of £83 billion. It has to borrow to meet the estimated budget deficit of £55 billion and also replace the borrowings that are due for redemption at much higher rates.
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