Financial Update from Brewin Dolphin - 30 September 2022
The Weekly Round-up
Friday 30 September 2022
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the fallout from the chancellor’s mini-budget and signs of weakness in the housing market.
Last week we discussed the poor market reaction to the mini-budget, which caused the pound to fall and bond yields to rise. At the beginning of this week, the challenges intensified with a collapse in sterling during thin trading in Asia; this was resolved by the increased liquidity of the European trading session.
Some commentators, and even a former member of the Monetary Policy Committee, were outspoken about the need for an emergency interest rate hike from the Bank of England. Weekly SONIA rates seemed to imply that rates would rise well ahead of the Bank’s next monetary policy meeting at the beginning of November. A statement issued by Bank of England governor Andrew Bailey confirmed that no action would be taken ahead of that meeting and clarified that monetary policy would be used to control the level of demand relative to supply (implying that currency management is not the objective). Sure enough, currency market stability seemed to resolve itself without the need for intervention.
On Wednesday, however, market stress returned and this time it was judged to require intervention from the Bank of England. The challenge was that long-dated bond yields were rising sharply. The UK’s defined benefit pensions market exists to meet liabilities which will become due decades in the future. These liabilities rise as interest rates fall and vice versa. Schemes naturally need to be insulated against these interest rate moves, while also making returns to meet clients’ retirement needs.
There are various ways of achieving this, but they end up involving gearing – using one asset to hedge the risk and another asset to generate the return. The first is often an interest rate swap, where the scheme agrees to pay a floating rate of interest and receives a fixed rate in return. Very little money has to be given upfront, leaving plenty of scheme assets to be invested for return. If interest rates rise, the value of the contract falls and the pension fund must post collateral (and vice versa). With swap rates rising sharply after the mini-budget, pension schemes were required to make these margin calls. Ultimately, this required the sale of assets including long-dated bonds, which risked pushing long-term swap rates up further and leading to a somewhat inevitable cycle of price falls driving greater margin calls.
In this instance, the Bank of England acted by announcing a significant potential bond buying programme. This saw yields fall and reversed a day of sharp falls for the market, most obviously for long-dated gilts but extending to all asset classes and most regions.
The move, which bore many of the hallmarks of quantitative easing, could have been interpreted as a loosening of monetary policy which would reduce bond yields. It has had that effect, despite only modest amounts of bonds being purchased.
As a reflection of how sensitive long-dated bonds are to changes in interest rates, bear the following in mind. In May 2020, as the pandemic struck, the government issued a bond to investors paying 0.5% interest (close to the prevailing yield at the time) which they would not repay until 2061. Before the pandemic, the yield had risen to 3.45% and because of the inverse relationship between bond yields and prices, that required a fall in price of about 64%. As the defined benefit pension scheme panic took hold, the price fell to just over a quarter of what it would eventually redeem at. Anyone brave enough to buy it before the Bank England’s intervention was able to realise a 45% gain as prices recovered – and if they were a UK resident, as with all capital gains on gilts, it would have been free of tax.
While pension funds employ very long dated swaps, the mortgage market uses zero to five year swaps to provide mortgages to home buyers. These have risen sharply, reflecting expectations of tighter monetary policy both before and after the mini-budget. During September, swap rates had risen from 3.5% to 4% because of expectations that interest rates would need to rise further. Since the mini-budget, they have risen from 4% to 5% so fast that mortgage providers were forced to withdraw their products because it became too difficult to establish a price for them.
The housing market is beginning to show signs of weakness already. Nationwide data released today showed that September was the first month since July 2021 in which house prices didn’t rise on average. Surveyors have seen new buyer enquiries fall and they expect prices to follow them.
This mirrors the situation in the US where prices declined during July by the most since the financial crisis. This will be welcome news for the Federal Reserve as falling house prices lead to lower contributions from shelter towards consumer price inflation. Sadly, it takes around 16 months for those declines to feed through into lower shelter inflation. This reflects the time it takes for house price rises to feed through into higher rents and the time taken for those rents to be suffered by tenants when their leases expire. This means that as house prices start to fall, their eventual impact on consumer prices will be relatively predictable, but it also means house price inflation will remain an upward driver of inflation for a long time yet.
Housing is one of the key factors within the economy that policymakers will focus on. The other is the labour market. This week saw a further reduction in new US claims for unemployment insurance, suggesting the labour market continues to tighten. Next week, a key focus will be on the non-farm payroll report, which is expected to show a further 250,000 jobs were created during September – about half the pace of the previous year.
The markets have suffered severely during this period of inflation and rising interest rates. Most of the declines suffered have reflected the inverse relationship between valuations and interest rates. Valuations now are back to their average in the US, despite the higher growth nature of the index. Valuations outside the US are below their average. Meanwhile, sentiment towards the equity market is very poor. So while the fundamental macroeconomic factors still represent headwinds for stocks, their valuations, sentiment and improved long-term return expectations argue against turning too bearish at this stage.
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