Analysis: Soaring energy prices create a perfect storm for UK bonds

City workers walk past the Bank of England in the City of London, Britain March 29, 2016. REUTERS/Toby Melville/File Photo

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  • UK gilts on track for biggest fall since 1994 ‘massacre’
  • Double-digit inflation set to rise
  • The government will borrow more to pay household fuel bills
  • Markets expect BoE rates to hit 4% as bond sales expected

LONDON, Aug 30 (Reuters) – Britain’s government bonds are on course for their biggest monthly decline since 1994 as soaring energy prices create a veritable storm of inflation, policy tightening monetary policy and the prospect of increased government borrowing.

Yields on interest-rate-sensitive two-year gilts — as well as 10-year bonds that factor in longer-term concerns about inflation and debt issuance — have jumped more this month than n any month since May 1994, when there was a crash in prices known as the ‘great bond massacre’.

“What we’re seeing right now is a market that’s seriously concerned about inflation levels, inflation persistence, inflation stickiness, and to what extent does that mean we might have a fairly tight monetary policy,” said Theo Chapsalis, bond strategist at Morgan Stanley.

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Two-year gilt yields hit their highest since November 2008 on Aug. 24 at 2.959%, ​​from 1.72% at the start of the month, and offered their biggest yield premium over German bonds since 2005. 30-year gilt yields hit their highest since 2014.

UK government bond prices have been under pressure all year, but the most recent selloff gained momentum after the Bank of England raised interest rates by half a point. percentage on August 5, its largest increase since 1995.

Higher-than-expected 10.1% inflation in July – the first time consumer price inflation hit double digits in 40 years – dealt another blow on August 17.

The BoE expects inflation to peak at just over 13% in October, but many economists believe it will go higher in early 2023, with Citi predicting a peak of over 18% – a level seen for the last times in 1976.

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GOVERNMENT BORROWING IS INCREASING

On Friday, Britain’s energy regulator announced that from October it would raise household energy tariffs by 80% to an average of 3,549 pounds ($4,177) a year, and analysts industry expect further increases next year to nearly double that amount. Read more

These increases don’t just mean higher inflation in Britain, but also a lot more government borrowing to subsidize the household bills of Liz Truss or Rishi Sunak who succeed Boris Johnson as Conservative leader and Prime Minister.

“It looks increasingly likely that a Truss government or even a Sunak government will step in with an emergency budget and likely significant measures to deal with the impact of rising energy prices,” he said. Imogen Bachra, rates strategist at NatWest Markets.

Neither Truss nor Sunak said what support they think is needed. Media reported on Sunday that Truss – the frontrunner in polls of Conservative Party members – is considering cutting the rate of value added tax from 20% to 5%, at a cost of around £38billion a year . Read more

The opposition Labor Party has proposed freezing energy bills, at a cost of around £60billion a year, of a similar scale to the COVID-19 pandemic furlough scheme.

In April, Britain announced it would issue £253bn of gilts in the 2022/23 financial year.

Uncertainty over the amount of additional borrowing led to British bonds underperforming those of the United States and Germany, Chapsalis said, as some investors feared Britain might need more money. issue 50 to 100 billion pounds of additional debt.

“This issue can and will be absorbed – but only at the right price. That price means higher yields,” he said, warning that long-term bonds such as those with 35-year maturities were most vulnerable to further price reductions.

Unlike the COVID-19 pandemic, when hundreds of billions of pounds of new debt were absorbed by the markets without leading to higher borrowing costs, today’s high inflation meant that bonds were no longer seen as safe haven, he added.

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HIGHER BOE RATES

Yields on UK government bonds are also being pushed higher by what markets see as a more hawkish BoE stance at the August meeting. The BoE said it was still ready to raise rates forcefully if needed, despite forecasts of a long recession.

Exceptionally, financial markets expect UK interest rates to rise above those in the US. The price of BoE rate futures peaks at 4.25% in June next year, compared to 3.75% to 4% for those set by the Federal Reserve.

However, most economists expect the BoE to raise rates much less. A Reuters poll shows BoE rates peaking at 2.5% at the end of this year. Read more

Chapsalis said the divergence likely reflected how financial markets were pricing not just the most likely scenario, but also a scenario in which the BoE might have to raise rates to 5% or 6% if it lost control of the economy. inflation.

The UK government bond market has also been facing headwinds since the start of the BoE’s bond-selling program next month. The BoE wants to reduce its holdings of gilts by £80 billion over the year through a combination of buybacks and outright sales.

While Chapsalis believes the impact will be minor, ING economist James Smith said the current volatility in the gilt market – with daily moves of more than 20 basis points – “casts a long shadow” over the sales program.

The BoE said it would only call off sales if markets are “very distressed”.

“We’re not arguing the plan should be shelved, but a clearer circuit breaker, which helps avoid escalating market stress, would make sense in our view,” Smith said.

($1 = 0.8496 pounds)

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Reporting by David Milliken; Editing by Christina Fincher

Our standards: The Thomson Reuters Trust Principles.

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