Conservative victory sparks short-lived bump in rates
The solid victory for the Conservative Party in the UK election has given investors a burst of confidence. But the rise in rates has proved short-lived and is unlikely to spark any supranational, sovereign and agency sterling issuance. Meanwhile, the outlook for the Bank of England has become slightly more hawkish.
While conditions for issuance are strong, SSAs are unlikely to take the plunge because of the time of year. “If it wasn’t mid-December, we’d be looking forward to a really busy week next week,” said the head of SSA debt capital markets at an investment bank. “But most people had made sure they had got everything done in good time before the election, which means there is very little left to do.”
The banker did say that for issuers nimble enough to access the market at short notice there was an opportunity. But an SSA syndicate head said he was sceptical that there would be any take-up.
“It would have taken a big move in the basis swap to provoke any real issuance,” the banker said. “A Labour majority was so unexpected that it might have sparked a big enough move to make an opportunity, but although this was a bigger win than expected for the Conservatives, I don’t think there will be a dramatic enough impact to persuade anyone to print.”
The sterling SSA market will kick back into gear in January. The SSA DCM head believes we are in for “a very strong early January”, but investors are concerned that, by then, the high triggered by relief that the Conservative Party had pulled off an impressive majority may well have faded.
“Frankly, it seems like a boost as we get to the end of the year, and not much more,” said James Athey, senior portfolio manager at Aberdeen Standard Investments in London. “Of course we have better clarity around Brexit, and the risk premium attached to a hard Brexit is unwinding, but in the immediate path forward, not all that much will change.”
He added that, because of the time of year, liquidity was low and that this was likely to exaggerate price moves. “We’re getting a big boost to risk just now, but in a few days that will be retraced as people take profits ahead of year end.”
Rate hikes or cuts?
The result of the election has, as expected, driven investors into riskier assets, and the sell-off in Gilts will send hawkish signals to the Bank of England’s Monetary Policy Committee. A rates banker said he was expecting a rate rise in November and a fund manager agreed, saying there could be a higher chance of a UK rate rise in 2020, but it would depend on who took the helm at the Bank of England.
However, Theo Chapsalis, head of UK rates at NatWest Markets, is still pricing in a rate cut in 2020. “There will be some pushback on Bank of England cuts, but we’re still pricing in a rate cut next year. The Bank of England will at least wait and see, and if the data shows a sustained improvement in confidence, then they might move more hawkish.”
Two other investors agreed. “The underperformance in Gilts will be short term,” said a rates investor in the UK. “If the improvement in confidence is to be sustained, we need to see business investment — or the economy will continue to stagnate. I can’t see the MPC hiking rates in that climate.”
Nevertheless, in spite of the problems remaining in the UK economy, dovish pressures have receded. “A week ago, a cut next year was a 50-50 chance,” said the analyst. “Now, that’s more like 25%. It’s still more likely than a hike, though.”
But inflation expectations have dropped sharply on the election result. Short term expectations have moved in response to the appreciation of the currency. However, the rejection of Corbyn’s high-spending manifesto has probably also removed fears of inflationary pressure, according to another analyst.
Gilt sell-off likely short-lived
While Gilt yields, particularly at the short end of the curve, have risen thanks to the Tory majority, the move is not as big as some expected. “We’re looking at around 3bp-4bp of extra yield at 10 years,” said a financial analyst. “That’s normal magnitude for a day without a general election result to digest.”
It is possible that the subdued reaction reflects not just that the market had anticipated a Tory majority, but also that some investors had feared a Labour-led government, which could also be expected to lead to higher Gilt yields because of Corbyn's plans to greatly expand government borrowing.
After the shock result in the 2017 election, when Labour did better than expected, confidence in the Tory poll lead was low.
So those were two reasons for investors to have been short Gilts before the election, and this could be why there has not been a stampede to sell them on Friday.
“We expected Gilts to sell off if the Conservative Party won because of clarity around Brexit and so forth,” said a second analyst. “But we were equally confident that Gilts would sell off on Jeremy Corbyn forming a government, because of the increase in borrowing. The small move in Gilts indicates that people were positioned for a Labour-led government as well.”
The long end of the curve has proved remarkably stable. “The market has been positioned in steepeners because of promised fiscal expansion, so we’re seeing a sell-off at the short end, out to five years,” said Chapsalis. “The long end cheapening, however, is largely in the price already.”
A financial analyst in London said investors might be underestimating the scale of fiscal expansion under the Conservatives. He pointed out that many of the Tory constituencies were new seats, and would expect immediate investment.
If the government surprises with a larger than expected fiscal boost, that should lead to still higher Gilt yields at the long end.
“There could be more moves to come at the long end, but that won’t become clear until we get a Budget,” he said. “But I do think Tory spending will be larger than was explicitly stated in their manifesto.”