Gilts vs Treasuries

Good morning. In the US stock market, the pattern of alternating very bad days and very good ones persists (Monday was good), a phenomenon we don’t particularly understand and don’t particularly like. Trendless markets are scary. There will be no Unhedged tomorrow; we’ll be back Thursday. Email us: [email protected] and [email protected]

All we can ever write about is gilts

In a nice bit of symmetry, the 10-year gilt and Treasury both closed right around 4 per cent yesterday. No doubt investing in the UK seems particularly perilous right now, but if markets are efficient, we should expect two risk-free bonds at yield parity to carry roughly similar risks. Which got us thinking: which would you rather own right now, gilts or Treasuries?

But first, a recap of what happened on Monday in gilts. Jeremy Hunt, the new chancellor widely seen as Britain’s de facto head of government, dumped £32bn of the “mini” Budget’s £45bn in unfunded tax cuts, scaled back an energy price guarantee and hinted at further spending reductions and tax increases to come. Ten-year gilt yields rallied a stonking 35 basis points while sterling rose 2 per cent against the dollar.

The market reaction looks like a plain reversal of what first scared markets about the “mini” Budget. Then, the worry was more Bank of England rate increases and much greater gilt issuance. Both pointed to higher gilt yields. Now, fewer unfunded tax cuts mean expected gilt issuance has been cut by £35bn, according to Ross Walker and Imogen Bachra of NatWest Markets. Markets take that to mean the BoE won’t have to go as high. The market-implied BoE peak policy rate fell 50bp from Friday, to 5.1 per cent.

Still, as we noted yesterday, the caveat is that UK markets remain distorted by pension funds’ forced selling, as this report from the FT points out:

Despite the fall in yields, pension funds said they were continuing to sell gilts in order to replenish their cash buffers.

“It was a bit calmer this morning, but the selling has not abated,” said Mike Eakins, chief investment officer of Phoenix, the £270bn manager which serves 13mn customers. “We are still seeing funds having to sell their gilts and we think there’s more to run on that.”

With that in mind, how do gilts now stack up against Treasuries?

Start with the argument for US bonds. Our Yankee intuitions scream: if the yields are no different, of course you want to buy America. America’s bond markets are deeper, its position in the world financial system more secure and its trend growth higher. The main risk is that raging inflation makes the Federal Reserve raise rates past 5 per cent. But with rates already restrictive and the Fed well aware monetary policy works at a lag, the case for it to pause will grow stronger next year. If US inflation is, as we think, a slow grind down from here, then a string of rate increases past 5 per cent isn’t overwhelmingly likely.

And if US inflation does run out of control, a smaller, more open economy like the UK’s will probably have the same problem — but worse.

Treasuries have been the less volatile of the two. Even before the “mini” Budget, 30-day trailing volatility has been higher in gilts than in Treasuries (blue line below). From Capital Economics:

Finally, NatWest’s Walker and Bachra point out that even after the latest fiscal U-turn, £175bn in new gilts is set to flood the market next year. Who will buy it all? The BoE is intent on quantitative tightening and natural buyers are hard to see. They write:

Aside from the BoE, the other major sectors of demand for gilts comes from foreigners (at the front-end) and pension funds (at the long-end) . . . with still a significant amount of political uncertainty, questions around the ability of this government to deliver spending cuts, and around the BoE’s policies, we don’t expect demand for gilts to be anywhere close to keeping pace with the increase in supply.

The conclusion is that gilt yields should still be higher than here: we revise our year-end target to 4.3 per cent. Markets are overestimating the changes to the issuance outlook on the back of [Monday’s] policy U-turns, we think, and will still have a significant amount of supply to digest over the coming months, which, with no support from the BoE, is likely to struggle to find a home even at these higher yield levels.

The case for gilts is thinner, but was made well to us by our regular correspondent, Columbia Threadneedle’s Ed Al-Hussainy. He points out that the UK yield curve is abnormally steep by developed-economy standards. Look, for instance, at the spread between the 30-year and 10-year gilts as of Monday:

The enormous spread, says Al-Hussainy, reflects a fiscal risk premium, in particular the risk that the UK issues boatloads of long-dated debt (in this case 30-year bonds) to finance spending. That risk is now shrinking, and will diminish further if Hunt follows through on his deficit-trimming suggestions. As the dust clears, a rally in long-dated gilts could follow. In other words: how much worse can things get?

This is a trade for the brave. Those who like sleeping easy, including Unhedged, will just take Treasuries at 4 per cent. But someone willing to bet that Hunt is for real might see exciting upside. Email us if that’s you. (Ethan Wu)

Mixed messages from earnings

In yesterday’s letter I wrote the following:

The Fed tightening is having a dramatic effect on financial conditions and markets, as well as the directly rate-sensitive aspects of the US economy such as housing. But that has left a lot of the rest of the economy all but untouched.

That view was based on a reading of last Friday’s pile of earnings reports from banks. Yesterday’s Bank of America earnings only confirmed the picture. While BofA says it is seeing spending among its millions of customers accelerate slightly, it is still growing at 10 per cent as of the first half of October — that is, still growing in inflation-adjusted terms.

Still, after pressing send on that letter, something rankled. That something, I realised, was FedEx. We mentioned the global (but US-centric) shipping company’s ugly earnings warning in Unhedged a month ago, when the company issued a stark warning about the quarter that ended in August. When they reported the quarter on the 22nd of last month, here is how one executive described the situation:

During the [August] quarter, manufacturing, global trade and consumer spending decelerated, particularly late in the quarter and certainly more than we anticipated. As a result, our first quarter volumes were lower than we forecasted. Our current expectations for 2022 US GDP growth and US industrial production forecasts have declined by about 100bp since June . . . Data shows that US consumer spending has slowed as inflation remains a challenge. Further, consumption is skewed towards services.

When the FedEx warning landed, we thought: this is how the hard landing starts. But the second view has utterly failed to drop. Yes, the final point in the above quote, about services versus goods, may go some of the way to explaining the poor fit between FedEx’s comments and on the signals coming from elsewhere. And shipping is a bit of a leading indicator, traditionally, whereas consumer spending is a bit more of a coincident or trailing one. But FedEx is not quite the only negative data point. We also see a slowing in real personal consumption expenditures (the last data point on this chart is for August):

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If this trend has continued, we would have expected to hear something about it from the big banks. But we didn’t. And the strong message from the banks was echoed, for example, by what we heard in Pepsi’s quarterly report last week. That company has offset its rising commodity costs by rising prices a lot, and customers have not even blinked. For Pepsi’s total portfolio of drinks and snacks, organic revenue growth was 16 per cent in the quarter; volumes were flattish. Consumers, in the US and worldwide, feel able to pay up. Then there is Delta Air Lines, which last week reported revenues 3 per cent ahead of the third quarter of 2019, before the coronavirus pandemic: “Consumer demand remains robust with improving demand for international travel,” and the holidays are looking good.

So far, the balance of earnings reports have painted a persistently strong US economy (excepting, of course, highly rate-sensitive businesses like investment banking and real estate). The few negative reports coming out of the core of the US economy, like FedEx’s, remain in the distinct minority. Recession, and a Fed pivot, may take a while to arrive.

One good read

Lots of people like to blame weak US oil production on goody two-shoes ESG rules. We don’t buy it. The bigger issue is that investors prefer payouts to new wells. Either way, oil people like drilling, and if they have to go private to do it, they will.