Searching for the UK’s ‘plonker premium’

With long-dated gilt yields at 21st century highs, it looks very much to the uninitiated like the bond market is throwing a full-on hissy fit. And given the level of political shenanigans, this is understandable.

But Alphaville readers are far from uninitiated. Or at least, they tend to be up for an initiation. So we thought we’d dig into whether a new UK ‘plonker premium’ exists, and how large it might be.

While the Prime Minister isn’t exactly popular among either voters or indeed the Labour Party, he’s sometimes seen as the least bad Labour leader by bond-types.

Moreover, City-folk — never hugely enamoured by prospective moves to the left at the best of times — look scared by some of the Green Party’s policy ideas. And as Sushil Wadhwani, former member of the Bank of England’s Monetary Policy Committee, reminds us, even if we don’t know what Reform UK actually wants to do besides deport people, Nigel Farage was on the same page as Liz Truss, calling her mini-budget that broke the gilt market the “best Conservative budget since 1986”.

So there’s at least some basis for thinking that any prospect of change from the status quo will shake the gilt market.

As we learned in bond boot camp, bond prices move inversely to yields, and short-dated bond yields are driven largely by expectations as to where the central bank will set interest rates over coming months and years. After all, only an idiot would lock in a 3 per cent interest rate on a two-year gilt if they expected to receive an average 4 per cent on cash in a bank.

According to our Bloomberg terminal, the latest market estimates for where the Bank of England will set interest rates in December this year is 4.35 per cent. At the end of February, before the recent political malaise, interest rates were expected to be a mere 3.20 per cent.

Could this rise in interest rate expectations be solely a function of Starmer’s loosening grip on power? Err, no.

It’s unlikely to have escaped even the most lackadaisical politico’s notice that, in addition to the civil war that has erupted in the Parliamentary Labour Party, other things have been going on in the world.

While Alphaville is loath to rule out any explanation of market prices — because who can really know for sure? — the rise in expected interest rates has coincided with a 50 per cent oil price shock that is widely attributed to events outside of Westminster.

The rise in energy prices has caused market-implied inflation expectations to leap in the UK, as elsewhere. The annual UK inflation rate in 12 months time is now priced to be a cool 5 per cent — more than double the Bank of England’s target — up from 3.5 per cent before Operation Epic Fury was launched. In the US year-ahead inflation is priced to rise from a prewar 2.5 per cent to a current 3.4 per cent.

The more extreme shifts in inflation expectations in the UK could reflect wobblier institutions and a tottering prime minister. They might also reflect the fact that the country runs on natural gas — the price of which has skyrocketed — and a record of exceptionally high energy inflation pass-through. They could reflect both. It’s hard to tell.

But with an outlook for higher inflation, the path of expected short-term interest rates in the UK (as well as yields on longer-dated bonds) have risen particularly sharply compared to the US:

Looking further afield

Slumping prices of long-dated gilts have attracted particular attention. Given the trauma of 2022, that’s understandable.

If we zoom in on the shape of the long end of the yield curve — the amount of additional yield you’re offered for taking longer-term UK interest rate risk — the curve does look pretty steep.

But it’s flatter than it has been on average over the past year.

And so this is not really the smoking gun we’re looking for. If you squint you can make out a lack of flattening over the past three weeks, at a time when the US curve has flattened. Perhaps long-dated UK bonds might have enjoyed the same in a counterfactual world.

Meanwhile, 10-year gilt yields have risen more the yields on 10-year government bonds of the US, Germany, France or Italy since the Strait of Hormuz closed to traffic. Until mid-April gilts were tracking Italian yield shifts. But they’ve since risen 25 basis points more than 10-year BTPs. They fell faster than European bond yields in the period leading up to the conflict, so again it’s hard to tell. But maybe this is the answer — that the plonker premium exists, and it’s somewhere around 25 basis points?

Let’s hold that thought and take a look at sterling. Because historically, UK risk premium has a habit of tanking the currency.

Hmm. Sterling is untanked. We realise that higher short-term interest rates could be supportive of sterling. So perhaps the thing that observers reckon is freaking out — short-term bond yields — could be the very thing that has prevented a currency collapse. This theory didn’t seem to help Liz Truss out back in 2022. But it’s possible.

Going full geek

One way we’ve sliced and diced yields before has been to ask whether there’s maybe some extra-special UK government risk premium — over and above the expected path for Bank of England overnight interest rates.

We’ve examined this by taking gilt yields, then swapping the cash flows into US dollars — first by using fixed-to-floating overnight index swaps referencing SONIA, then by applying cross-currency basis swaps, and lastly by using floating-to-fixed OIS referencing SOFR. You can look back at this old post for more on this methodology (if you’re really bored, can’t sleep, possess an inquiring mind, or have trust issues).

But for the rest of you — ta da! We’ve manufactured a synthetic 10-year US dollar bond with UK government issuer risk. And we can compare its yield to the 10-year US Treasury yield. Maybe the spread tells the story of political blow-up risk. And while we’re at it, let’s do the same for Japanese, French, Italian and German 10-year government bonds:

It’s not screaming plonker premium.

This could be because political chaos is being priced into the path of Bank of England interest rate expectations. And arguably, this is the sort of thing that emerging markets specialists will be familiar with: the central bank is forced to buttress investor confidence by implementing higher rates than the economy would normally be calling for.

Whatever the case, it doesn’t appear to show up as some special additional risk premium in ten year gilts.

The experts

To be clear, we’re not saying that the UK doesn’t have a plonker premium. In fact, perhaps our earlier, simplistic 25 bps estimate — derived from comparing UK and Italian government bond yield movements since mid-April — looks decent.

Because, as Pantheon Macroeconomics’s Robert Wood argues, with the UK’s fiscal rules looking less secure, maybe the way for this premium to genuinely emerge is through a higher path for the Bank of England’s interest rates.

Taking this approach, Pantheon reckons gilt yields would be 45 basis points higher in a world without Starmer. Moreover, they reckon that four-fifths of this already priced. Four-fifths of 45 bps = 36 bps.

Given all the noise around UK politics, you might think it weirdly reassuring that this only leads to a 25-36 bps extra bump on gilt yield. It shouldn’t be.

Firstly, because with debt-to-GDP uncomfortably close to 100 per cent, a sustained 25-36bps on Bank of England short rates and gilt yields adds billions of pounds annually to interest payments.

Secondly, because bond and currency markets can throw hissy fits. Sure, 25-36bps doesn’t qualify as one. But if this is where we are before any hissy fits are thrown, it means that panic mode — should we get there — would be a LOT worse than this. Whether we get there is another matter.

Further reading:
— How to (more) properly compare bond yields across markets (FTAV)