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The immense pressure of the war in Iran is poking out in some strange corners of the financial markets, such as Korean stocks and Romanian debt. Every asset class and commodity is taking some kind of strain.
It is hard, in that environment, to pick the market moves that really matter. This week’s wild ride in UK government bonds is, I think, one of them. It is an early warning sign of how a commodity shock, in oil and gas, can morph into a bond shock that hurts government finances far and wide and jacks up borrowing costs for us all.
UK and European government bonds have been the rather unlucky financial-market victims of the bombing of Iran from the start. A lot of very similar, very crowded bets among hedge funds, all anticipating further declines in interest rates, hit a wall as the abrupt rise in oil prices awoke inflation from what had appeared to be a nice nap. The unwind turned a modest drop in bond prices into a pretty large drop in bond prices and left the gilet brigade with egg on their faces.
This week’s scenes in UK government bonds, however, were on a different scale. They came after the Bank of England took the rather dull and predictable path of keeping interest rates on hold. No surprises there. But traders had been expecting at least one of the nine rate setters to plump for a cut in interest rates again. Instead, the decision was unanimous. In addition, the central bank erased its previous guidance that the next move in rates is likely to be down.
The BoE kept its options open and stressed that it’s not set on a jump in rates. Nonetheless, its pronouncement hammered gilts, especially those with a two-year maturity — the part of the market most sensitive to the likely path of interest rates. Prices plunged as investors braced for multiple rate rises, sending yields up by 0.3 percentage points and still higher on Friday. That may not sound like much, but to put it in context, you have to go back to the famously disastrous “mini” Budget of late 2022 to find anything on the same scale. A weird overreaction? Maybe. And as always, context matters. This move, while painful, leaves the two-year yield at its highest point in a little over a year, at about 4.6 per cent.
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But it really underscores the fear that the war will unpick years of patient work by policymakers to tame inflation and try, at least, to fire up economic growth. The spectre of stagflation stalks the land.
In addition, it sheds a very uncomfortable light on the fact that, in the words of Jeff Currie and James Gutman at investment firm Carlyle, “you can’t print molecules”. Central banks cannot flood the system with oil in the same way as they can flood the system with money, in order to make this problem go away. Strategic oil and gas reserves will get you only so far. This grim episode is (another) wake-up call to governments everywhere that it’s foolish to rely so heavily on the Middle East for energy. They simply have to spend a lot of money, from taxpayers and bond markets, to build domestic resilience.
“An energy-secure Europe needs to own its resources if it is to own its future,” the Carlyle duo wrote in their note this week. “This requires localisation, diversification and redundancy. Investment in renewables, nuclear and the grid will need to be aggressively expanded to maximise the resources Europe has in abundance — wind and solar, engineers and technology . . . The burden of the energy price increase will fall unevenly . . . Countries with fiscal capacity and access to credit will outbid those without, and both will look to reconfigure relationships.”
Fiscal capacity and access to credit. Constraints there appear to be what the markets are picking off now. It is no secret that the UK is limited on both fronts.
Bear in mind that the two-year yield that rocketed this week is particularly pertinent here. The UK was for years the developed country with the longest debt profile — it enjoyed a cushion from the fact that it borrowed with much longer maturities than its peers. Now it is among many developed countries including Japan and the US that have bowed to structural and economic factors and shifted towards shorter-term debt issuance instead.
Already, rich countries are still borrowing recession-like amounts of money from bond markets in (for now) a non-recessionary environment, as the OECD highlighted in its recent global debt report. As it also noted, the UK, while still a relatively long borrower, has carefully engineered one of the steepest declines in average issuance maturities among G7 nations. This makes sense for a number of reasons but it does inject additional refinancing risk — a near-constant need to go cap-in-hand to the bond market at what now look like more jumpy rates.
A whole host of rich nations have flipped to shorter-term borrowing just as shorter-term borrowing costs are in danger of kicking higher and just as a grey swan energy crisis threatens to ramp up the need to borrow much more. This is not a pleasant spot for governments to be.
katie.martin@ft.com
