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This hasn’t been a great week for Keir Starmer. It also has not been a great week for UK government bond prices. Which also means it hasn’t been a great week for anyone looking to refinance their mortgage. How much of this is the Labour party’s fault and how much is down to bigger structural forces they ultimately have little control over (like the price of oil)? For those who only read the first paragraph: I think the structural forces are more important over the next few years than the current Labour palace intrigue (though more market-friendly tax and borrowing policies would surely help). And, I am afraid, I think these longer-term forces will keep rates higher for a while.
My list of the reasons why is below. Note that most of these apply equally to the US, UK and Europe. One reason I think UK rates will stay high (however the politics resolves itself) is that I think global rates will stay high. Whatever you think of current UK policy, gilts tend to move more in line with US treasures and German bunds than they do on specific UK political headlines.
- Inflation is above target and rising. The energy price shock is obviously the cause here. Hormuz remains closed. In many respects, energy markets are remarkably well-behaved given some of the dire predictions that were floating around in March, but oil is still above $100 a barrel and this week saw a nasty pickup in US input inflation. After getting it very wrong in 2022, central banks will be less likely to look through the shock and interest rates look more likely to rise than fall in the short term.
- Economic numbers remain steady. US payroll growth numbers last week were strong and even the UK managed 1.1% year on year GDP growth in Q1 (compared to expectations of 0.8%). If the economic growth is holding up (as it is) then the case for lower interest rates is weakened (especially with above target inflation)
- Government deficits remain high. The US deficit is still running at -6.0%. The UK is better at -4.3% but this is still hardly good. And Germany is upping borrowing to invest in defence. If governments are spending and borrowing, central banks offset this boost to the economy by keeping rates higher. Of all the major economies, the UK is probably doing the most to try and tighten its budget (via higher taxes). But uncertainty over what might come next after Keir means we are not getting much if any credit for it today.
- AI investments are huge and increasingly debt funded. As I wrote last week, AI-related data centre investment has been the dominant market theme this quarter. The numbers are enormous (see below) and increases are now funded via debt rather than corporate free cash flow. Again, this is more supply for the bond market to absorb. And more supply means higher interest rates are needed to attract investors to lend the money.
- And finally, a UK specific issue: defined benefit pension schemes are buying fewer gilts. Defined benefit pension schemes were a large structural buyer of gilts. But as these schemes are slowly being replaced by more equity heavy defined contribution offerings so this demand is melting away. This is one reason why UK longer-term yields are so high (the 30 year gilt yields 5.8% today). This, plus ongoing Bank of England selling, is keeping UK yields higher for longer.
I continue to think that inflation will start to fall again after the oil shock and that UK growth is weak. This argues for lower UK rates. But equally, I have thought this for a while and lower rates have not arrived. I therefore am now paying more respect to the longer-term forces I list above. And, absent a socialist revolution inside Number 10, I think these forces are what will continue to be what matters for UK investors. If you are looking to re-mortgage, I’d not be budgeting for a better deal any time soon.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
