A Blast from the Past: Base Rate
The UK base rate has remained at 0.25% since August 2016, two months after the Brexit vote. This low interest rate was meant to stimulate economic growth in the UK, which has been achieved. It has also led to an inflation rate beyond the Bank of England target of 2.0%- from 0.6% in August to a staggering 2.9% in May.
However, there have been concerns regarding low wage growth in the UK (2.1% in May) & lowering retail sales, which hints a lack of confidence in customers and businesses, and raises questions about the UK economy’s capacity to support an increase.
Rather unsurprisingly, this has led to an unchanged target interest rate of 0.25% in June at the Bank of England Monetary Policy Committee (MPC) meeting. However, what was shocking was the 5-3 split against hawkish shifts.
This very narrow hold might stem from a very high inflation rate (2.9%) reported in May as members in the MPC are worried there has been a too drastic increase in price of goods. To reverse this effect, interest rates will rise soon unless reports about UK wage growth, released this Wednesday, have a darker twist. Only time will tell.
How Does This Affect Bond Yields?
Low interest rates seem to pair well with bonds, so an increase in interest rates causes the bond market to worsen. When there is a higher interest rate, the coupon bonds offer is less attractive, and so more investors sell their bonds, pushing the bond price down.
As a direct effect, this pulls up the bond yield. Even though a greater bond yield may sound attractive, investing in the bond will be more speculative; the risk of default will be seen as greater as there will be a smaller money supply.
UK 1-year Gilt yield: The 1-year UK government bond yield has increased sharply from mid-June to a peak of 0.353% on 6 July. The increasing bond yield is from the increased chance of a hawkish shift- this started after the 5-3 Bank of England Monetary Policy Committee result and continued after Mario Draghi’s surprise comments on 27 June, hinting that the European Central Bank may stop or reverse Quantitative Easing.
This may lead to investors selling stocks to buy cheap UK government bonds, thus pushing down the value of stocks- FTSE 100 fell from 7,550 points at the beginning of June to 7,350 points.
In the future there are expectations that the bond yield will drop to reach a more stable level if the Bank of England MPC result leads to an interest rate above 0.25%. The initial surprise of hawkish shifts has gone and so investors are predicting a higher interest rate by the end of 2017 at the very latest.
UK 10-year Gilt Yield: The volatility of the UK 10-year Gilt yield has increased, where it has stooped down as low as 0.931% on 14 June and then rose to 1.309% on 7 July. With UK government bonds of a longer period, there is more volatility primarily because the UK interest rate can drastically vary over 10 years & the economic stability of the government can drastically change.
However, the increase in yield was caused by Draghi’s hawkish comments about reversing Quantitative Easing on 27 June as described above. Alongside this on 6 July, a EU-Japan deal was announced which means there is a lower chance of a Brexit deal in favour of the UK.
This led to investors feeling less confident, resulting in a higher bond yield. Currently, 10-year Gilt bonds are seen as less attractive due to uncertainty in the UK’s access to the single market and forming a trade deal after Brexit. This will continue in the future unless there is more confidence in the UK.
A Glimpse into the Future:
While there have been prominent increases in 1-year and 10-year Gilt yields, the yields will become more level in the near future with lessened volatility. The initial shock from the investors has disappeared, from the EU-Japan deal to potential hawkish shifts.
However, contrary to 1-year Gilt yields, 10-year Gilt yields will remain high as on the maturity date of the 10-year Gilt, the UK will not be an EU member. Therefore, the UK government bonds will be seen as less attractive until there is more certainty within the UK parliament and about Brexit.
Even though Brexit’s consequences cannot be determined fully, with the hope of a ‘very, very quick’ UK-US deal and reasonable access to the EU, the UK economy will continue to grow & Gilt bonds will become increasingly attractive with a less volatile, lower bond yield.