It has been a V-shaped year for UK gilts. Starting the year at nearly 2%, the ten-year yield fell to 0.5% during August but has rebounded to 1.4%. Is the ten-year gilt approaching good value again?
Real Yield and Inflation Expectations. One starting point is to break the nominal yield down into expected inflation and a real yield. Interestingly, the rally to 0.5% was driven largely by a decline in real yields but the climb back to 1.4% was mainly due to rising inflation expectations. The real yield is off its absolute 2016 lows but remains very subdued by past standards at -1.75%.
The chart gives a longer view. During the 1990s and the early 2000s, the real yield and the breakeven inflation rate roughly tracked each other. If the nominal yield was 4%, then the chances were that the real yield was 2% and the breakeven similarly 2%. However, from 2003 onwards the real yield continued to decline while inflation expectations moved broadly sideways. Currently, the nominal yield of 1.4% comprises a real yield of -1.75% and expected inflation of over 3%.
Expected Inflation Too High. Even noting that UK index-linked gilts are tied to the RPI rather than the CPI, the rise in breakeven inflation looks overdone. Sterling’s fall is the root cause of this move but, unless the pound continues to fall, the increase in actual inflation will be short-lived. We expect CPI inflation to approach 3% next year but then to ease back to around 2%. Thus, ten year gilts have some protection in the form of over-done inflation expectations.
But Can Real Yields Remain Deeply Negative? Economists are not entirely sure what drives real yields. There are plenty of theories but not much conclusive analysis. After a few moments’ thought, we have come up with seven likely drivers of real yields:
- Global yields – international government bond markets have a strong herd instinct, often driven by the US Treasury market. Where the ten-year Treasury yield leads, others (mostly) follow.
- Larger debt/deficit – in most economies, public debt ratios and budget deficits are higher since the financial crisis. This is certainly true for the UK, boosting the supply of gilts.
- Growth prospects – whether you call it “secular stagnation” or “productivity puzzle”, there is a malaise affecting growth in the UK and elsewhere. We expect UK growth to slow next year.
- Ageing population – the retired population is increasing rapidly and, with it, the propensity to save.
- Declining capex growth – for whatever reason, businesses are investing at a slower pace now than twenty or thirty years ago, which means fewer physical investment opportunities
- Political uncertainty – the three big votes of 2016 (in the UK, the US and Italy) have resulted in increased political uncertainty, giving investors an incentive to head for the safe haven of government bonds.
- Inequality – whether income or wealth inequality, the outcome is greater flows into financial assets, including the most liquid asset of them all, government bonds.
Investment Conclusion. The above seven influences are carefully ordered. Broadly speaking, we reckon the first two are negative for gilts at present but the latter five are positive. Thus, there are good reasons to like gilts at these levels but there is a distinct danger that further increases in US Treasury yields could overwhelm all else. Our view is a cautious buy for now.
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