An ordinary popular delusion

Financial markets in the UK have started the New Year in an odd frame of mind. In summary, according to a number of market commentators, the recent fairly dramatic increase in ten-year yields in the UK has been prompted by concerns over the increase in government borrowing announced in last October’s budget. According to the accepted narrative, this has undermined confidence in the gilt market and may lead to an emergency statement from the Chancellor announcing either further tax increases or spending cuts.

At the margin, other factors have been implicated in this story. For example, UK inflation, which has picked up since the 1.7% print in the Autumn, is now also being cited as a reason for this market wobble, which in turn has led to some interesting moves in the equity market. This argument is that the recent increase in inflation, which is likely to peak at about 2.8% in the next month or so, will spook the Bank of England’s rate-setting committee and prevent it from cutting rates. This, along with what’s been going on in the gilt market, has led to some significant near-term falls in interest rate-sensitive sectors like housebuilders and retailers.

Regular Woodford Views readers may recall an article from October last year entitled Popular Myth Massacre that might shed some light on these market histrionics. In it, I showed the relationship (well, in truth, the complete lack of a relationship) between gilt yields and the deficit, and between economic growth and the debt to GDP ratio. In summary, my analysis shows that, contrary to what most commentators seem to believe, there is no observable relationship between these variables.

On the other hand, there is a very clear and tight relationship between gilt yields and inflation and between gilt yields and bank rates. So, at least part of the popular narrative that has led to a wobble in financial markets in the first full week of the year has some credibility.

In other words,

1. The increased deficit, a result of the measures announced in the October budget, is not the culprit behind the spike in the 10-year gilt yield to nearly 4.8%. The media has just got this wrong again.
2. If the Chancellor were to respond to this as the media has speculated, by announcing some emergency measures, this would be very silly indeed.
3. It’s important to remember that higher deficits and higher borrowing have not inhibited growth here in the UK over the last 70 years.
4. Fears of higher inflation and the impact this might have on official interest rates could have been the culprit, however. The problem with this explanation is that the higher inflation we are likely to see in the next few months is, in large part, the direct product of the tax increases announced months ago in the budget and consequently known to the MPC. The most recent hints given by the Governor of the Bank of England on rate reductions in 2025 were provided in full knowledge of these impacts. So, my guess is that this explanation is also wrong and is something else the media is also mistaken about.

So, if the media has once again grasped the wrong end of the stick, it begs the question: What is responsible for the significant increase in the ten-year yield?

I believe the culprit is what is happening in the US to 10-year Treasury yields. These are rising because the market there is beginning to become more concerned about the inflationary impacts of Trump’s tax-cutting and tariff-increasing policy agenda. This is something I have also commented on recently. In summary, I am more relaxed about this than the market appears to be. Indeed, I find myself agreeing with the ex-Fed governor, Ben Bernanke, who very recently said, “Trump policies……probably will be modest in terms of their effect on the inflation rate”. I also think that energy prices are more likely to fall than rise under a Trump presidency. So, I am not as concerned as the market is, but the fact is that in the short term, at least, this is something that has concerned investors in the US.  And as a result, 10-year Treasury yields have risen to about 4.7%.

This, of course, leads us to ask, what makes me so sure that this is the cause of a similar rise in UK yields? Here again, I will refer you to long-term history, which shows an incredibly high correlation between US and UK 10-year yields over the last 38 years. And if anyone doubts this relationship still exists, the line chart shows US and UK 10-year yields over the last year or so.

Summary

What we are seeing in the gilt market is not the product of some sort of consensual shift in inflation expectations here in the UK, and neither is it the product of heightened concerns about the level of government borrowing. On both fronts, the media consensus explanation for what is happening in UK financial markets is wrong. More prosaically, it is the product of the US market’s concerns about the inflationary consequences of the incoming Trump administration’s tax and tariff policy agenda.

Having said that, these concerns have had a real and quite significant impact on gilt prices and on a number of UK interest rate-sensitive sectors in the equity market, including housebuilders and retailers. I will return to this subject in future blogs, but suffice it to say here that I expect this hiatus to be temporary and its impact to be reversed in the weeks and months ahead.