It is hard to overstate exactly how extreme these moves are. The excess volatility and sheer speed with which these yields rose, in what should be a relatively stable market, caused the BoE to step in on Wednesday.
The pension industry was suffering, and a mismatch between assets and liability opened up quickly, raising margin calls that prompted further gilt sales to fund margins, exacerbating the situation.
The BoE released the break, pausing the quantitative tightening programme, and simultaneously slammed the accelerator and initiated a new unsterilised quantitative easing programme.
The immediate effect of this action was a rally unlike anything seen in a developed world government bond market. The 2073 nominal gilt rallied 41 per cent from its lows into the close, the 2073 inflation-linked gilt more than doubled in price terms.
Yes, you are right in what you are probably thinking now: QE should, all things being equal, add to inflation, it is stimulative. Adding to the UK’s inflation problem in the same week the BoE was due to tighten monetary conditions extends both the government and the BoE’s troubles.
Why is the central bank turning 180 degrees and seemingly making the inflation problem worse? To stop the UK government bond market from imploding.
Now there appears to be relative calm in the debt markets again, attention turns to the currency. Sterling is weak and has sold off aggressively since Friday.
A model used by the BoE suggests that for every 10 per cent depreciation in the currency (on a trade-weighted basis) UK inflation could increase by around 1.5 per cent at the headline level.
Conflicting policies are now at the heart of the problems facing the government and the central bank.
How should investors navigate this market? In my mind, an allocation to very short-term nominal gilts makes a great deal of sense, and avoiding credit spread in what is likely to be a recessionary environment. Yields have risen in anticipation of more rate hikes from the BoE, designed to suppress inflation expectations.
This does present investors with an income stream that gives the asset class its name back. The short-end recommendation means that the bonds will mature in the near future and allow the investor to roll the cash proceeds into another short-term gilt and potentially benefit from an even higher yield.
The other asset class that deserves a place in a portfolio is longer-dated inflation-linked gilts. Given the recent turmoil, these gilts now offer investors true protection from inflation; real yields – that is, the yield available after the effects of inflation – are positive for the first time in a decade.
