Bonds as we all know are promises, promises to repay money to the owner of the bond at a future date. Therefore it shouldn’t be a surprise to anyone that trust in the issuer (the borrower) is of paramount importance in the assessment of the fair price, and by implication yield (interest rate) on a given bond at a point in time. In a parallel to the above Arlingclose due diligence services for our clients help identify a fair price for loans that they might issue to bodies who apply for them.
Gilts are bonds too, bonds issued by the UK Government, and although inflation and growth are important factors, political events can contribute to significant changes in the price of these Gilts. In fact we have arguably seen a significant move in Gilt prices that has in part been caused by politics, by which we mean the recent Conservative Party leadership contest which has been won by Liz Truss.
Throughout her campaign Truss has arguably demonstrated less fiscal constraint than her counterpart Rishi Sunak, and she has undermined the continuity that markets tend to favour. Just some suggested measures include unfunded VAT and tax cuts worth at least £30bn, which may come from headroom in the current budget, but which could end up being funded by borrowing. She has further undermined certainty by mooting changes to the independence of the Bank of England.
The financial markets haven’t liked the Truss message all that much…higher borrowing and lower taxes make the repayment of debts all the more difficult. Add to that the fact that a loss in trust leads to higher refinancing and borrowing costs exacerbating and extending the affordability squeeze.
According to the latest available DMO figures, overseas holders of Gilts account for 28% of the market at the end of Q4 2021…and if you exclude the holdings of the BoE accumulated through quantitative easing then this rises to in excess of 42%. Should foreign owners sell then you would expect to see a slide in the currency and indeed from the 3rd January to the end of 5th September we saw Sterling slide from $1.35 to $1.16 to the Pound.
Gilts are perhaps on the edge of a precipice, markets are finely balanced like three legged stools, credibility and trust make up one leg of that stool and should that be worn away too much then a very uncomfortable tumble may well follow. When falling down a steep slope momentum gathers quickly, sales of Gilts lead to painfully higher yields, weakening currency leads to imported inflation, eroded purchasing power to a shrinking economy.
After the shocks of recent times a visit to the IMF would definitely be something to avoid in our opinion. Credibility must be restored, a responsible fiscal plan put in place, appropriately targeted support notwithstanding.
Placing your Truss in the Bank of England