By Robin Marshall, Director of Fixed Income and Multi-Asset Research, FTSE Russell
The UK gilt yield curve became fully inverted in both mediums and long maturities in April. Chart 1 shows there is now no yield pick-up, but a yield discount between 1-3 years gilts and 7-10 years, and between 1–3-year gilts and 20+ years. This also means there is negative carry down the curve, with UK base rates at 4.25% and the highest yields available those on 1-year gilts at close to 4%. Note that during the Taper Tantrum in 2013, investors received a yield premium of 200-300 bp for holding long maturities over shorts, not a discount, and even in 2021, they were rewarded with a pick-up of 70-100bp in 7-10 years and 20+ year maturities.
Short yields are at 10-year highs, with a very flat yield curve
Such a flat, or inverted, curve defies conventional theories of the term structure of interest rates, and the notion investors require a yield premium for holding longer dated maturities, given inflation risk over a longer period, with a fixed nominal coupon. Chart 2 shows the absolute yields on gilts of different maturities, and the convergence towards 4% in 2022/23, as the Bank of England raised base rates to 4.25% to combat inflation. The Chart shows these are historically high yields in the post-GFC era, and particularly at the front end.
Structural and cyclical factors have driven yield curve flattening…
A range of factors have driven yield curve flattening in the UK. Structurally, asset/liability matching by institutional investors increased demand for longer dated gilts. In addition, declining yields since the Global Financial Crisis in 2008/09 created a vicious circle of lower yields increasing pension fund liabilities, boosting demand further for longer dated gilts with known cash flows and maturity dates, driving long yields lower again.
Cyclical forces also played a part. Yield curves often bear flatten during tightening cycles, as short yields rise more than long in response to higher policy rates. Longer yields rise less because markets tend to anticipate a decline in inflation, and recession, and lowering of policy rates in the period ahead.
…apart from A/L matching, a flat curve leaves little incentive to own long gilts.
With yields similar across the yield curve, and no additional yield on offer for holding longer dated gilts, investors require other reasons for holding longs, particularly as shorts now offer the highest yields for over a decade, with no credit risk, and capital surety. For investors required to match future liabilities by holding assets with known cash flows and maturity dates, there are other reasons for accepting the lack of extra yield protection, and risk from higher duration. But strongly negative 12 month returns in long gilts show the risks inherent in owning long duration assets in a rising rate environment, with negative carry and rising funding costs, as displayed in Table 1. Also note the gilt market has a duration of 9.23[1] years compared to only 7.63 years for the FTSE World Government Bond Index.
Judged by 2020/21, the yield curve may bull steepen if the BoE moves to ease policy?
Looking ahead, if the UK yield curve bear flattened during recent policy tightening, will the curve disinvert, or change shape when the BoE eases? The only pronounced monetary easing in the last 10 years was the post-Covid period of March 2020 - 2021, when the BoE eased base rates by65bp to 0.1%, and resumed QE, creating positive carry down the yield curve, as the spike in Chart 3 shows. The yield curve then steepened in 2020/21, first due to short yields falling faster than long yields (bull steepening) and then bear steepened from August 2020 onwards due to long yields rising faster than short yields, as inflation fears increased (see also Chart 2 above), giving strongly negative returns in longer maturities.
Not all steepening are born equal and 2022/23 experience highlights duration risks
Should this monetary and economic cycle develop similarly, with base rates and short gilt yields already at 4-4.25%, there is scope for a significant bull steepening, if markets front-run BoE policy easing, once UK inflation falls more decisively, favouring strategies designed to maximise carry. However, the experience of 2022 - 23 highlights the dangers in long duration in the gilt market and the attractions of short maturities, with yields at 4%, already at 10-year high.
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[1] FTSE Actuaries UK conventionalGilts All Stocks Index.
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