Stubborn inflation, cheaper gilts

This week, the UK was presented with inflation data that despite being touted by the Prime Minister Rishi Sunak as progress, should in our view be seen as anything but. While headline inflation fell from 10.1% to 8.7%, this still left the rate a full 0.5% higher than expected and more importantly involved a rise from 6.2% to 6.8% in Core CPI – which excludes the more volatile food and energy price changes (and is thus seen as a better predictor of ongoing inflation).

April’s number included a 6.9% rise in services inflation. We find this particularly worrying because there’s no obvious benign catalyst to reverse embedded services inflation; global supply chains may continue to smooth, commodity prices have as much scope to normalise as spike but ultimately rising unemployment is the most likely remedy for labour market tightness pushing services higher. While economists repeatedly point to one-off reasons for higher inflation in the UK, there always seems to be one more one-off to keep CPI higher. Those negotiating wages just see the trend and it’s through wages that transitory inflation becomes embedded, and the data suggests UK inflation is close to being entrenched.

These fears that inflation will remain stubbornly high and necessitate further hikes from the Bank of England resulted in an immediate sell-off in gilts - pushing the 10 year yield 20 basis points higher on Tuesday morning. While market pricing now implies an additional 100bps of hikes from the Bank of England can be expected. In this backdrop gilts have drifted higher throughout May and have continued to sell off this week following the inflation data – leaving yields 60bps higher across the yield curve.

In terms of relative value however, we think this is somewhat reassuring. The ECB only has 50bps of hikes priced in while Europe looks to be facing equally worrying core inflation and wage trends. Given how far gilts have already shifted, a downside shock as Bunds catch up is very possible. While arguments can be made that US inflation is on a better path, expectations of multiple cuts within the next 12 months, despite current FED rhetoric, leaves treasuries vulnerable in our view.

Recalling the crisis that pension schemes suffered as their LDI strategies required swift margin payments during the UK’s mini-budget debacle in September – what’s the danger that another vicious cycle of long-end gilt selling breaks out again? Capital calls for pension schemes were already beginning last Friday and the continued move higher in gilt yields this week will surely lead to more. However, having had 8 months to prepare, and regulatory pressure to do so, today LDI schemes are holding far more collateral to cover gilt moves and operate with less leverage. This means there is more headroom in the system before forced selling of gilts and should allow for a smoother rebalancing of assets – but it is headroom rather than immunity. All LDI participants are effectively following the same strategy so if collateral is breached long gilts would be offloaded by all, at the same time, with no obvious buyer. As a consequence we’d expect pension schemes to earnestly rebuild collateral as it’s used up – and this means outflows from risk assets.

So while the underlying technical for sterling credit has been very positive of late - with a lack of supply of new issuance from corporates and the Bank of England very close to finishing its corporate bond selling - if gilts continue to sell-off we need to be prepared for that technical to reverse as credit becomes a source of liquidity. We take comfort in the strong underlying fundamentals of UK credits and the buffer higher yields and spreads help provide but we think it makes credit selection and active management all the more important.

In comparison to last September, the moves in gilts we are seeing are less aggressive and that is very much a positive for smooth functioning markets – but from the UK Government’s point of view, there’s no obvious lever to pull to reverse them. Given how much pessimism is already priced into gilts there’s no particular reason to think they need to cheapen more but if they do so, there’s no spending spree or tax cuts to cancel and firing the Chancellor won’t cause an immediate rally this time. Inflation is the Bank of England’s fight here, tight monetary policy can eventually tame it but it becomes an increasingly painful medicine, both to prescribe and to take.