UK Gilts Send Markets Spiralling Following Truss Financial Package Announcement

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UK Market Update

The Bank of England (BoE) delivered another 50 basis points (bps) rate hike at September’s Monetary Policy Committee meeting. It also voted unanimously to proceed with quantitative tightening plans by starting its active sale of gilts on 3 October at a pace of £10 billion per quarter. More significantly for the markets, Liz Truss’ government announced a £45 billion unfunded tax-cut package. Together with the BoE’s perceived hawkish tone, the fiscal package triggered an aggressive sell-off in gilts (see Chart of the Month below). This set off an unwinding of many exposures in the liability-driven investment fund space, which led to a mass selling of long-end gilts as pension funds sought to raise cash for their investments within these funds. To prevent several pension funds from collapsing, the BoE announced a £65 billion emergency bond-buying programme (and delayed its quantitative tightening plans) for the long-end gilt market, which eventually quelled volatility.

Eurozone Market Update

The European Central Bank (ECB) raised the deposit rate by 75 bps to 0.75%, its largest move in history, as the recent peak in inflation called for greater concern around Europe’s overall inflation outlook. President Christine Lagarde signalled that interest rates would be raised further “over the next several meetings” to increasingly dampen demand and contain inflation expectations. ECB projections show Europe avoiding recession in both 2022 and 2023. Elsewhere, the ECB’s temporary removal of the 0% cap for government deposits led to a spike in front-end euro yields. The two-year bund spiked 23 bps — its second biggest move since 2009. The swap market ended the month implying a 2% interest rate — a 125 bps hike — by year-end.

US Market Update

As anticipated, the Federal Reserve voted unanimously to raise rates by 75 bps to 3.00-3.25%. Chairman Jerome Powell noted that some members suggested a 100 bps hike. There was another noticeably higher shift in the committee’s rate expectations and acknowledgement that rates will continue moving into restrictive territory even in the face of softer economic growth. Headline inflation rose 0.1% in August, but the core component jumped 0.6%, while the annual increase came in at 8.3% and 6.3%, respectively, for headline and core inflation. Interest rate expectations are now 100 bps higher for both 2022 and 2023, with the median year-end rate at 4.25-4.50%. Current Fed funds futures contracts are pricing in a 75% probability of another 75 bps hike in November.

Looking ahead

Attention remains focused on the UK’s market volatility and uncertainty. The reaction of the BoE will be under scrutiny to ensure financial markets don’t become dysfunctional as we saw in longer-dated gilts and to combat higher inflation due to the unfunded tax-cut plans. Following widespread international and domestic pressure, a reversal of at least some of the plans is likely. If this happens, market expectations of BoE hikes will decrease, and UK gilt yields will fall. Away from the UK, our base case for the ECB is a further 75 bps hike as we expect medium-term inflation to remain above 2%. In the US, if inflation remains high and labour markets tight, which we expect, a further 75 bps hike at the Fed’s November meeting is likely. Our portfolio positioning will continue to be cautious.

Chart of the Month: UK Mini Budget Triggered Unprecedented Gilt Sell-off

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