Are higher yields here to stay?

Transcription

1 Are higher yields here to stay? UK Month in Charts FTSE Breakeven Inflation USD per GBP LIBOR Spread Corporate Spread Real Yield Series plotted relative to the closing position in the previous month. This edition of EconForum examines the factors that have resulted in the recent pickup in yields in the UK and US. It then looks at the dominant trends that are likely to push yields higher and the factors that may temporarily restrain the upward moves in yields, resulting in higher volatility. UK Market Review The FTSE 100 index rose 3.5% from 5675 to 5875 over the first week of November, before falling back to 5528 on Tuesday 30 November 2010, a 2.6% fall over the month. Part of the fall over the latter part of November can be attributed to increased concerns over the euro-area sovereign debt crisis, which has resulted in fears for the future of the euro-area. Over the same period, MSCI US equities fell by 0.1% and MSCI Europe ex UK equities fell by 6.7%. There has been an increase M SCI US Equity Nov 10 in volatility in global stock markets with the VIX index rising 10.8% from 21.2 to 23.5 over the month. However, volatility has since fallen by over a fifth, with the VIX standing at 17.6 on 10 December The above charts show the evolution of the daily time series over the past year relative to the horizontal axis, which is set at the last closing value of the last Friday of the previous month. The close of play values at the end of the last four weeks are shown as bars. A bar below the horizontal line indicates that the series has fallen below the value on the last Friday of the previous month. Conversely, if the bar is above the horizontal line the series is above value on the last Friday of the previous month. Page 1 of 15

2 15 year breakeven inflation has risen from 3.1% to 3.2% over the month, in response to higher oil prices and positive economic data. UK CPI inflation rose from 3.2% in October to 3.3% in November. In the year to November, RPI annual inflation was 4.7% up from 4.5% in October. Core CPI inflation remained unchanged at 2.7% in November Crude Oil per Barrel ($) The corporate bond yield (based on the non-gilts iboxx 15+ AA) increased from 5.2% to 5.5% while the 15 year gilt yield increased from 3.7% to 3.9% over November. Therefore, the corporate spread, as reflected by the difference between corporate bond yields and 15 year gilt yields, remained stable widened from 1.5% to 1.6% over the last month. The rise in the yields can in part be attributed to positive Q3 GDP growth that effectively ruled out the prospect of further quantitative 4.8 Gilt Yield Nov 10 easing over the remainder of 2010 and some increased concern over higher inflation. Over the last month, the real yield has remained around 0.6%. Sterling strengthened against a basket of the major currencies in November, again supported by stronger-than-expected Q3 GDP growth. The sterling effective exchange rate index rose 1.5% from 80.2 to 81.4 over the month. In particular, sterling depreciated against the US dollar, falling 2.5% from $1.60 to $1.56 over the month. Against the Euro, sterling appreciated 4.3% from 1.15 to 1.20 over the month Sterling Effective Exchange Rate The LIBOR spread (the difference between the rate of interest at which banks borrow funds from each other and the base rate) remained around 0.2% over the month. In November s MPC meeting, the Monetary Policy Committee (MPC) kept the bank rate at 0.5% and maintained the existing level of quantitative easing at 200bn. This month s no-change decision is likely to be repeated over the next few months. The Committee remains of the view that significant risks to inflation lie in both directions. The recovery now appears to be based on rather stronger foundations than earlier this year. In particular, net trade accounted for half of Q3 s 0.8% rise in GDP. The announcement of plans for an additional fiscal stimulus in the US obviously leaves the outlook for global demand looking a bit brighter too. Consequently, further QE is unlikely to be undertaken by the Bank of England in the near term unless the economy experiences a sharp downturn. Page 2 of 15

3 Are higher yields here to stay? The UK government bond market has experienced a pickup in yields since the start of the 4th quarter. The causes of this rise in yields, which is far from a UK phenomenon, is a matter of debate. An important point to note is that though the rise in yields is significant against the levels seen in September, yields had fallen very sharply through the summer months. Even after a 40 basis point move up from the late summer lows, 10 year gilt yields are only back up to where they were in July and are still 74 basis points lower than at the start of the year. Our view is that there are some important forces which are now coming through to push up gilt yields, but there are also some powerful factors which are working in the other direction, keeping yields lower than they would be otherwise. This article discusses these cross currents in the gilt market that are battling it out for supremacy. Our view is that the balance of probabilities suggest that medium-term factors supporting higher yields are now in the ascendancy. However, we also recognise that the trend towards higher yields does face some strong obstacles. One consequence of this is higher gilt volatility, a by-product of the highly unusual economic circumstances of our time. This gilt market behaviour is a challenge, but could also offer opportunities. Reasons for near term rise in yields International factors contributing to the rise in yields UK government bond yields have been heavily influenced by international developments. UK 10 year government bond yields have risen closely in step with rising yields in the US since the start of October (see chart right). The rise in yields can primarily be attributed to growing optimism over the US economic recovery (where annualised GDP growth was revised up from 2% to 2.5% in the third quarter). Furthermore, the improvement in the economic outlook may have also led to a reassessment of the chances of further expansions in US monetary policy, as recovery would imply that future quantitative easing would not be as large (or might be halted sooner) and that short rates might rise at an earlier date. Since the announcement by the Federal Reserve to purchase a further $600bn of government debt (Quantitative Easing 2) in early November, expectations for higher US inflation have only contributed to a small part in the recent rise in US yields. Decomposing 10-year nominal treasury yields into the real yield on treasury inflation-protected securities (TIPS) and the residual breakeven inflation rate suggests that the latest jump in nominal yields is almost entirely due to a pick-up in real yields. (From the beginning of November to 14 th December US treasury yields jumped 83 basis points, 94% of this move being attributable to a 78 basis point increase in the real yield). Page 3 of 15

4 Domestic factors contributing to the rise in yields Domestic factors have also reinforced the upward move in government bond yields. Like the US, the UK has experienced reasonably healthy economic growth. UK growth over the second and third quarters of 2010 was far stronger than economists had forecast, rising 1.2% and 0.8% respectively. This has led the Office for Budget Responsibility (OBR) to revise upwards its forecast of GDP growth for 2010 from 1.2% to 1.8%. Forward looking indicators for economic growth, such as the recently released CIPS/Markit manufacturing survey, suggest that the recovery remains on track. This has helped to allay fears of a deep double-dip recession within the short to medium term. Market concerns over the outlook for domestic inflation have intensified. Increases in global commodity prices and VAT, and the continued stubbornness of domestic consumer price inflation have contributed to an increase in higher future inflation expectations. There has been a pick-up in breakeven inflation rates (the difference between nominal and real government bond yields) over the last quarter of The increase in nominal 10 year gilt yields partly reflects a rise in real yields and a somewhat larger rise in break-even inflation rates. Long term breakeven inflation has risen. 15 year breakeven inflation (which relates to RPI inflation) was 3.5%. After allowing for a CPI-RPI differential and an inflation risk premium, this number suggests a view that inflation could exceed the Bank of England target of 2% CPI inflation. This concern over inflation partly reflects the persistence of the inflation target overshoot, as well as the uncertainties created by quantitative easing. Inflation intensifying short term could push yields up further The latest inflation report from the Bank of England suggests inflationary pressures are likely to intensify in the near-term (although this pick-up is expected to to be temporary the Bank of England is obviously thinking hard about this). Headline CPI inflation rose from 3.2% in October to 3.3% in November, while core inflation remained steady at 2.7%. November s producer price figures suggest that cost pressures in the industrial sector are still strong. Input price annual inflation is heading towards double digits, rising 9% in November compared to a rise of 8.2% in October. Annual output price inflation was 3.9% in November, a level that is clearly inconsistent with the MPC s 2% CPI inflation target. Consequently, producer prices will put further upward pressure on CPI inflation going into next year. Furthermore, the forthcoming rise in VAT and continuing increases in import prices, due to the past depreciation in sterling, are also likely to push inflation further above the 2% target in the near-term. This, in turn, may reduce expectations of further quantitative easing in the UK and may bring forward the risk of early interest rate rises. (Should CPI inflation rise above 4%, we suspect that this may force the issue of early interest rate rises). Against this background, gilt yields could clearly rise further in the near-term. However, the trend towards rising yields is not without challenge There are also some powerful factors restraining the upward move in yields. Perhaps the most important factor keeping bond yields under check is the relatively low likelihood of any rise in official interest rates in the major economies. The Fed s main policy rate is likely to remain at current low levels until unemployment falls Page 4 of 15

5 significantly, and this could be some time away. With the front of the US yield curve anchored in the way that the Fed has done, there are limits to how far yields can rise. However, further quantitative easing is likely to be limited due to political pressures and questions over its efficacy over the medium term. There has recently been a domestic backlash against the Fed s use of quantitative easing, which might make it harder to expand quantitative easing in the future. Another factor that acts to slow the rise in yields is the strength of the economic recovery. Advanced economies are only now just starting to emerge from recession. While growth rates have generally surprised to the upside (due to overly pessimistic or cautious forecasts), it is not clear if growth has become self sustaining. Much of the rebound has come from inventories, and private sector engines of growth; consumption and investment have generally been feeble. In the US, investment did make a comeback, but latest indicators suggest this is fading. With the enhanced fiscal stimulus of the payroll tax cut in the US, the chances of reasonable growth through some part of 2011 have increased, but there are risks. Higher bond yields could slow the more interest-sensitive parts of the economy, in turn limiting the rise in yields. And we have to remember that economic growth is still constrained by the damage done to the balance sheets of households and financial institutions, stemming from the collapse in housing prices and the related financial crisis. Deleveraging, particularly by consumers is unlikely to be over. What about the outlook for inflation? Arguably, benign inflation behaviour in most developed economies, particularly in the US, has been the biggest friend of the bond market. In the US, the recovery so far has been a jobless one, with unemployment remaining high at 9.6% in October. If growth does not accelerate markedly due to private sector deleveraging and general caution, unemployment will likely remain high and core CPI inflation is likely to keep moving lower for some time. Though rising commodity prices are proving a challenge, it can, however, be argued that this is unlikely to prompt a material and lasting rise in global inflation at a time of generally weak demand and large amounts of spare capacity in the world economy. Furthermore, commodity prices may themselves be peaking (see chart right). Global commodity prices may start to fall back as doubts grow about the strength of final demand both from the West and China, and speculative flows reverse out of commodities. A big question hangs over US public finances and its impact on bond yields. Given high net public debt, standing at around 63% of GDP at the end of October 2010 and with deficits now likely to stay close to 10% of GDP in 2011, there is understandable concern over public finances, which is one of the reasons why yields have been moving higher. It is also clear that the US should implement a sizable fiscal contraction within the next few years if it is to protect its AAA credit rating and avoid its own debt crisis. The unavoidable fiscal consolidation will hamper growth as public spending is tightened and taxes eventually rise. It is therefore possible that growth falls back as expectations of the necessary fiscal tightening takes hold. However, given the delay in fiscal consolidation to 2011 at the earliest, this does not look to be a material factor restraining yields in the near term. Rather, the reverse. Page 5 of 15

6 UK gilt yield drivers There are also some specifically UK factors that are driving the outlook for gilt yields. The most important restraint on the upward move in UK gilts is the Bank of England's anchoring of short-term interest rates. This could continue for most of The key reason for this is the possibility that growth disappoints. Against a background of public spending cuts, raising interest rates could prove unsettling for household finances, given the support that has come from low mortgage interest rates. Though official forecasts point to respectable above 2% growth in 2011 and 2012, these forecasts may be too optimistic, as it is not fully clear that the economy can withstand the impact of such a major fiscal contraction. Problems in the Eurozone, the UK's biggest export market, could keep external demand subdued. Finally, weak money and credit growth is also a factor that restrains growth. On the other hand, the persistence of inflation at relatively high levels is pointing to difficulties for the Bank of England in holding rates steady. Of course, if growth weakens sharply on the back of the public spending cuts, putting downward pressure on inflation, gilt prices will be supported. However, without a major relapse in economic growth, it is hard to see gilts recovering the levels of support seen a few months ago. In any case, it is possible that weak growth can coexist with elevated inflation pressures, at least for a time. General inflation expectations are at fairly high levels, not easy to reconcile with the Bank of England's target. It is true that some part of the persistence of inflation can be explained by the weakness of sterling. But there is concern that inflation has come in higher than expected for a considerable time, and it has come through into inflation expectations. If this carries on, any natural downward move in inflation (from weakness in commodity prices, for example) can be delayed or not happen at all. While the Bank of England may still opt to keep rates steady because of concerns over growth, the neglect of its inflation target and over some loss of its antiinflation credentials could keep pressure on gilt yields. Summary There is a clear tussle between the factors that are pushing yields higher and those that are restraining the upward move in yields. Key factors that suggest that recent pressure on yields is unlikely to reverse are is the growing optimism about the global economic recovery, a reassessment of the chances of further quantitative easing and a higher anticipated profile for interest rates. Equally, we recognise that there are some checks and balances to this rise in yields. Key factors that might assert downward pressure on yields are interest rates remaining at unusually low levels until spare capacity and unemployment is reduced, the risk of a sharp downturn as developed economies all implement severe fiscal contractions to improve the health of their public finances and the threat of further mass quantitative easing being undertaken in response to a global shock, such as a widespread euro-area default on sovereign debt. That said, our overall view is that yields are now unlikely to fall back in a sustained fashion, and that the medium-term direction of yields is higher. However, given the restraints on rising yields that we have discussed, we anticipate a continuation of volatility, and a number of periods when the direction of yields is likely to be unclear. Page 6 of 15

7 Implications This turn in the interest rate cycle has implications for pension funds in terms of asset allocation. Pension liabilities could be helped somewhat by rising yields, though there is more sensitivity to real rather than nominal yields. We would be happy to analyse the implications and choices to be made following from this change. Accounting During November, the accounting deficit for Britain s largest 200 final salary schemes pension scheme deficits stayed relatively stable, increasing by only 2bn to stand at 71bn at the end of the month. The accounting deficit has been considerably more stable during 2010 than in recent years. The volatility of the deficit during 2010 has been at roughly the same level as it was in 2006 suggesting that the reverberations caused by the financial crisis have died down during the year. Stability in the balance sheet is generally welcomed as it means that employers are more easily able to predict how their end of year accounts might look. Employers should also note that Government proposals to link private pension payments to the Consumer Prices Index (CPI) rather than the Retail Prices Index (RPI) are expected to be reflected in most Company accounts prepared at the end of December. This could result in a reduction of 35 billion to the deficit of the 200 largest pension schemes. Funding A return to volatility in equity markets during the month with the UK equity market ending the month slightly down, whereas overseas equity markets were flat, at least for those schemes who have not hedged their currency exposure. Government bond portfolios largely held their value, with income compensating for small falls in prices arising from slightly higher yields. Corporate bonds fell in value, as yields rose more quickly than Government bonds. Overall, asset values are likely to be slightly lower than at the start of the month. However, the small increase in bond yields taken together with largely unchanged inflation expectations, would lead to slightly lower liabilities. Taken together, funding levels are likely to be little changed over the month. - 40bn - 50bn - 60bn - 70bn - 80bn - 90bn - 100bn - 110bn - 120bn Nov Jan Mar May Jul Aug Oct Week 1 Aon 200 Index Week 2 Week 3 Week 4 Source: Aon-Hewitt Whilst care has been taken in the production of this EconForum and the information contained within, Aon does not make any representation as to its accuracy and accepts no liability for any loss incurred by any person who may rely on it. In any case, the recipient shall be entirely responsible for their use of this EconForum. Page 7 of 15

8 Appendix All charts are as at close of business on 30 November 2010 except where stated otherwise. LIBOR The graph below shows the extra amount banks have to pay above the Bank of England base rate to borrow and lend to each other. The LIBOR rate is the London Inter-Bank Offered Rate that is one of the global benchmarks for the cost of borrowing. It reflects the ability and willingness of banks to lend and as such it can be considered as a barometer of banks faith in each other. During the last month, the 3-month LIBOR rate spread remained around 0.2%. 3.0% 2.8% Spread between Bank of England Base Rates and 3 month UK LIBOR Collapse of Lehmans and bail out of AIG 2.6% 2.4% 2.2% reduced to 4.50% reduced to 3% Interest Rates reduced to 2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% reduced to 4.5% raised to 4.75% Interest rates raised to 5.75% raised to 5.5% raised to 5.25% Credit crunch Central banks global intervention Banks stop lending to each other hence central Banks become the only lender in the markets Interest rate reduced to 0.5% Interest rate reduced to 1% Launch of Quantitative Easing Gilt auction failure 50bn QE extension 25bn QE extension General Election % 0.0% -0.2% raised to 5% reduced to 5.5% reduced to 5.25% Interest rate reduced to 5% reduced to 1.5% -0.4% Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Page 8 of 15

9 Currencies The graph below shows the value of the US dollar relative to a basket of seven of the world s major currencies including the Euro, Canadian dollar, Japanese yen and British pound. Against a basket of other major currencies, the US dollar index rate increased 3.7% from 72.1 to 74.8 over the last month. 95 USD vs a Basket of Major Currencies Index Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Source: Federal Reserve Page 9 of 15

10 The other two graphs shown below are the effective exchange rate of Sterling and the Euro. These rates are calculated using the weighted average against other major currencies and then converting them into an index using a base period. During the last month, the UK Sterling index rose 0.2% from 81.2 to 81.4 while the Euro index fell 4.% from 97.0 to Effective Exchange Rate Index, in Sterling (Jan 2005 = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Effective Exchange Rate Index, in Euros (1990 average = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Page 10 of 15 Source: The Bank of England

11 The graph below shows the value of both the US dollar and the Euro relative to Sterling (i.e. relative to 1). Sterling depreciated against the US dollar, now buying $1.56 (against $1.60 at the end of October). Against the Euro, the value of sterling appreciated, now buying 1.20 (against 1.15 at the end of October). USD, Euro vs GBP since January US Dollars Euros Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep US Dollar vs UK Sterling EU Euro vs UK Sterling Page 11 of 15

12 Equities UK equities rallied in October with the FTSE 100 index fell 2.6% from 5675 to Over the same period, the FTSE 100 implied volatility index increased 25.5% from 19.6 to However, as the wider equity market backdrop still looks uncertain, the UK equity market looks set to continue to experience greater volatility. Price level of FTSE 100 UK Equity Index 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Page 12 of 15

13 Fixed Interest The credit spread increased from 1.5% at the end of October to 1.6% at the end of November. Corporate bond yields (based on the non-gilts iboxx 15+ AA) rose from 5.2% to 5.5% while the long term gilt yields rose from 3.7% to 3.9%. Over 15 Year Gilt Yield vs Corporate Bond Yield 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Corporate Yield Gilt Yield Credit Spreads between Iboxx AA 15+ Corporate Yield and Gilts 15+ Yield 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Source for both graphs: DataStream iboxx AA+15 yr yield vs Gilts +15 yr yield Page 13 of 15

14 The Shape of the Gilt Yield Curve The yield curve is a measure of the market s expectations of future interest rates given the current market condition. The shape of the yield curve should normally be upward sloping, i.e. the interest rate you should receive for lending your money to someone should increase as the term of the loan increases. The graph below shows the UK gilt yield curve on 5 November, 12 November, 19 November and 26 November It can be seen from the graph that short-dated yields remained stable while medium-dated and long-dated yields rose significantly over the month. 4.90% UK Government Bonds Yield Curve 4.40% 3.90% 3.40% 2.90% 2.40% 1.90% 1.40% 0.90% 0.40% 1 Years 2 Years 3 Years 5 Years 7 Years 10 Years 15 Years 20 Years 30 Years 5-Nov Nov Nov Nov-10 Source: Bloomberg Page 14 of 15

15 Property The IPD UK Monthly Total Return Index below is the benchmark for most UK property funds. The index continued to rise but at a slower pace, rising only 0.6% from 756 in September to 761 in October. The fears that credit conditions may be tightening again and the possibility of renewed weakness in the labour market will continue to weigh on property market. UK IPD Total Return Index 1, For further information and questions, please contact: Mark.Jeavons@aonhewitt.com Editor: Mark Jeavons Theme Author(s): Mark Jeavons Tapan Datta Sub-Editors: Trevor Connor Sarah Abraham Regular Contributors: Andrew Firth Andrew Claringbold Yusuf Samad END Page 15 of 15