The Bank of England has more work to do, according to markets. Locking in today’s rates by owning UK Gilts looks attractive, particularly for UK taxpayers.
Simon Nathan, Head of Cross Asset Trading
Samuel Zief, Head of Global FX Strategy
Matthew Landon, Global Investment Strategist
Our Top Market Takeaways for June 26, 2023
Market Update
Battling the uncertainties
Global stocks saw their first loss in four weeks.
There’s no shortage of worries batting around: U.S. regional banks still face challenges like the possibility of higher capital requirements, some activity measures have gone on the backfoot (see Friday’s purchasing manager index readings), China’s recovery has been losing momentum, geopolitics continue to rear their head, the Fed is holding resolute on its call for two more rate hikes, and the Bank of England and Norges Bank delivered their own heftier-than-expected 50bps hikes last week.
But while inflation has decelerated across much of the developed world, price pressures remain particularly hot in the UK. In today’s note, we take a deeper look at the unique challenge facing the Bank of England and what this means for portfolios as interest rates soar.
Spotlight
Hit for six
2022 was one of the worst years on record for bond investors as central banks raised rates aggressively to combat rising inflation. The UK has been no exception, with the Bank of England hiking from just 0.25% to 5.0% today, pushing Gilt yields to heights not seen since 2008.
The U.S. and Europe are starting to see the impact of higher rates on their economies, with activity momentum waning. But signs of slowing have been harder to find in the UK, with risks of overheating growing. Look no further than last week’s UK CPI print, which came in above consensus for the fourth consecutive month. Although there was some easing in food and energy components, core inflation reached a new record high of 7.1%, as a red-hot labour market drives wages and inflation broadly higher.
The top chart shows core CPI inflation in the UK, Europe and U.S. from January 2018 to May 2023. The UK line starts at 2.7% and fluctuates around the 2% level until April 2021, after which core inflation steadily rises to its series peak in May 2023 of 7.1%. The Europe line remains between 0% and 1% from January 2018 until July 2021. From there, core inflation rose to its peak of 5.7% in March 2023 and has since fallen slightly to 5.3% by May 2023. The U.S. line remains flat around 2% from January 2018 until February 2020, where it falls close to 1% before rising sharply to a peak of 6.6% by September 2022. Since then, core inflation has fallen some way to the most recent level at 5.3%. The bottom chart shows wage growth and unemployment rate for the UK from 2005 to 2023. Wage growth starts at 4% and unemployment rate just above 2% in January 2005 and remain around those levels until April 2008. From there, the unemployment rate surges to a series peak of 8.4% in 8.5% in November 2011 and wage growth drops to below 1%. The unemployment rate then steadily declines over the next decade to 3.8% by September 2019 and wage growth had risen to 3.8% by the time. There is an uptick in unemployment as wage growth falls into negative territory in June 2020, before a decline to series lows for the unemployment rate as wage growth surges to 7.2% by the end of the series.
That backdrop drove the Bank of England to up the ante on its pace of rate hikes to 50bps last week, taking the policy rate to 5%. And while the BoE argued that 50bps wasn’t the new normal in their policy statement, markets are currently pricing a 75% chance that we see a move of the same magnitude in August.
Where do we go from here? It’s hard to pinpoint where the BoE will land. In just the last month, bond markets have priced in a further 100bps of hikes from the BoE to a terminal rate in excess of 6%, a level not seen since 2000.
This line chart shows the market-implied policy rate for December 2023 for each of the Bank of England, Federal Reserve and European Central Bank. The BoE line begins at 4.5% before falling below 4% by the beginning of February. From there, the implied policy rate jumps to 4.9% by March 7. It then drops sharply to slightly above 4%, before climbing steadily for the rest of the series to a peak of 6.1%. The Fed line starts at 4.5% and remains there for most of January before rising steadily to a peak of 5.6% by early March. There is then a steep drop off to 3.7% just a few days later, from where the rate has risen to today’s level of 5.2%. The ECB line starts slightly below 3.5% and fluctuates around that level before climbing to a series high of 4% in early March. A drop to below 3% is then followed by a steady increase over the following months to end at 3.9%.
Vital to determining the path forward is how the BoE will balance the risks of not doing enough (resulting in inflation becoming entrenched) with doing too much (which could have serious implications on the housing market and growth more broadly). So far, we don’t think we’ve seen enough evidence of cooling in inflation and the labour market for the BoE to think about stopping with rate hikes. Based on what we know now, we see three or four more hikes from here before the BoE is able to pause.
Markets are taking notice: the lure of higher interest rates has also attracted global investors to the UK bond market over recent months. That has helped sterling to reach its strongest level against the dollar since last April and its strongest vs. the euro since August.
8These line charts look at the performance of pound sterling year-to-date. The top chart looks at GBPUSD level since the start of 2023. A higher GBPUSD level means that GBP is stronger relative to USD. The series begins around 1.20 and initially rises to 1.24 in January before falling to a series low of 1.18 by early March. From there, the level rises steadily to 1.26 on May 5 before pulling back slightly and then rallying to a high above 1.28. The latest reading is slightly off highs at 1.27. The bottom chart looks at EURGBP level since the start of 2023. A lower EURGBP level means that GBP is stronger relative to EUR. The series initially fluctuates between 0.88 and 0.90 for much of January and February. Since then, there has been a steady decrease to a series low around 0.85. Current levels are marginally higher.
That said, this level of high rates is now leading to worries around a potential recession late next year. Currency markets have even started to factor in this concern over the last week, with sterling’s rally being halted despite support from higher interest rates..
Investment implications
Seize the opportunity
Despite the challenges, we see opportunities for investors. With bond market yields already pricing in more than 100bps of further tightening in an environment of slowing global growth, markets are already pricing in a lot. Today’s Gilt yields offer investors compelling yield and a meaningful buffer from any further shocks higher. Should rates fall, Gilts may offer investors an opportunity for capital appreciation potential, as well as income and protection benefits that “risk-free” yields close to 5% already embed.
Not only that, but there is an added benefit for UK resident taxpayers given that UK Gilts are exempt from capital gains and losses.
When bonds are issued, they normally pay a coupon reflective of the interest rate environment at that point in time. Over the last 10 years, many of these bonds have been issued with very low coupons (as central banks kept rates at emergency low levels). As interest rates have moved higher over the last year, the price of those low coupon bonds have fallen significantly. That means that most of the yield on UK Gilts today is realised through a capital gain at maturity. Since only the coupon income is taxed, there are several bonds on the market with very low coupons and a low bond price that we think look extremely compelling versus deposits and other taxable investments.
As an example for UK resident taxpayers, let’s consider a UK Gilt with a coupon of 0.25% maturing on 31 January 2025. For illustrative purposes, let us say that bond trades at a price of 92.40 (i.e. 7.6% discount to par) and yields 5.23%. That bond will pay 0.25% per annum coupons in January and July on the total amount invested. For additional rate taxpayers the income would be taxed at 45%, meaning the 0.25% (the coupon income) would reduce by 0.11%. The capital gain from 92.40 to 100 at maturity is exempt from capital gains tax, meaning that the net after-tax yield would therefore be 5.12% (5.23% - 0.11%). To find comparable taxable investments, you would need a gross equivalent yield of over 9% (5.12% / 0.55 = 9.31%). Considering that UK Gilts are also seen as a “risk-free” asset, we think this presents a compelling opportunity.
Finally, an important point to consider when investing is currency risk. We think that this is particularly true when discussing the pound in today’s environment. Interest rate support looks to be waning as investors focus on the potential growth implications of higher rates instead. While the opportunity in UK Gilts is evident, we might look to also trim some GBP positions beyond that in order to right-size currency exposure in portfolios.
For more details on these ideas or to hear our latest thinking across global markets, please be sure to reach out to your J.P. Morgan team.
All market and economic data as of June 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
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