Can UK afford to finance its debt?
The prospect for gilts is going to be a vital question for the UK government as it goes about the process of exiting the EU. Can the government continue to afford to finance its debt, and will UK investors get the kinds of returns that they're used to? Christopher Peel, the chief investment officer at Tavistock talks to the FT's Kate Allen about why he has a negative outlook on gilts.
Filmed and produced by Petros Gioumpasis
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I'm here with Christopher Peel, the Chief Investment Officer at Tavistock, he's got a really negative outlook on gilts
Now the prospect for gilts is going to be a vital question for the UK government in the coming months and years as it goes about the process of extracting itself from the European Union? Can the government continue to afford to finance it's debt, and will UK investors get the kinds of returns that they're used to?
Christopher, you first chart introduces us to this subject, can you talk us through what it's showing?
Yes, the first chart is showing the relationship between UK CPI inflation and 10 year gilt yields. And what it shows is that over the last 25 years, there's only been one period where inflation was greater than the 10 year yields. So, negative real returns in 10-year gilts. So I read that as something this is most likely unsustainable over any meaningful period of time, and either inflation will have to come lower, or bond yields will have to rise.
And so this is a potential period of operation that we're in at the moment. You don't think it's going to last very long, is that right?
I don't think it's going to last very long, because I think we'll start to see central banks reduce their quantitative easing programmes, and the government is under pressure to abandon its 1% public sector wage cap, which will likely increase wage push inflation. So the rate of inflation, even though it was a little bit better a couple of days ago when it came down to 2.6%, I think that forward forecasts are right when they're looking at a number closer to 3.5% to 4%.
So in addition to that macroeconomic outlook, you also perceive some quite significant risks building in the gilt market, which you don't think are widely perceived. I think your second chart illustrates this quite well. Can you explain to us what this is showing?
Well the change in risk has been stealth like over the last 20 years where the average duration in the gilt market has risen from a approximately six years to 12, which is a function of the government borrowing at the longer end of the yield curves, and investors looking for you for higher rates of return. So they're going out the yield curve, down the credit curve to enhance income in their portfolios.
And so this means that it's going to take gilt investors longer than they realise, it will, to get repaid the kind of returns that they're expecting, right?
Well, what it means is the losses will be exactly twice what you would expect if you were a bondholder 20 years ago, meaning if rates rise by 1% back then, you would have lost 6% of your capital. If they rise by 1% today, you'll lose exactly 12%, and the other key thing is that given that the level of rates is so low, the average yield in the gilt market is 1.6%. If that goes up to 2.6, it's still going to take the better part of five years to get your losses back.
And in addition to that, there's the international picture here, which I think is also relevant. Now your third chart here shows us-- it gives us some insight into that international picture in terms of central banking activity. We're in a period of unprecedented central bank intervention in the bond markets. You see that as a further downside for gilt pricing.
Well, I think the benefits of QE have largely diminished. The central banks own $13 trillion US worth of government debt, and most of which they'll probably hold to maturity. But what they-- what their first step will be is to stop buying bonds in the secondary market, which will put upward pressure on bond yields for the auctions to clear in the open market.
So, less-- the removal of a very large buyer from the gilt market, potentially, further downward pressure on gilt prices. As an investor this is a very negative outlook.
Very negative outlook, and I think the average investor, retail investors, aren't aware that the duration has doubled in the last 20 years.
Hmm. Great. Thank you very much, Christopher.