Gilts: U-turn talks prompt rally for the right reason this time

Liz Truss’s Thatcherite mantle is poised to slip again. The lady may be “for turning” on tax cuts bigger than the 45p personal rate whose abolition she has already reversed. Prices for 30-year gilts rallied and yields fell 35 basis points to 4.55 per cent on Thursday afternoon.

That was reassuring to the same extent that earlier yield drops triggered by Bank of England intervention were worrying. This time, the move reflected hopes the UK economy would be better managed. Before, yields fell in response to short-term BoE mitigation of the opposite expectation.

The problem is that many in the UK have begun fetishising lower gilt yields in the way that Thatcherite Tories once fetishised strong sterling. The BoE’s responsibility is to avert financial panics. It does not have a duty to keep long-end gilt yields artificially low to oblige pension funds with ill-judged derivatives bets.

Yields need to rise to dampen price pressures in the economy. With UK consumer price inflation pushing towards 10 per cent, expecting yields to hold fast below 5 per cent is unrealistic. Expect them to move towards parity with inflation over time.

The bank’s temporary bond-buying programme ends on Friday. After this “cliff edge” passes, calm will either be restored or panic will resume. BoE Governor Andrew Bailey expects the former.

That does not mean volatility will never return, but at least one cause is now better understood. Interest rate derivatives were at the core of the implosion of LDI strategies. Here, pension funds typically bought derivative insurance against falling interest rates that cost them heavily in extra collateral as yields rose.

The proliferation of LDI strategies partly explains why five of the 10 largest daily moves in 30-year gilt prices since 1989 occurred in 2022, according to Refinitiv data. Four of the largest five occurred in the past three weeks.

Knock on effects from LDI might also explain why four of the 10 largest daily moves in the 10-year gilt also took place this year. LDI does not explain why the five largest daily moves in 30-year US Treasuries over the period all occurred in March 2020.

Financial instability, by its very nature, tends to be unforeseen. Responsible politicians should not add to market uncertainties as the Truss government has done. Tax backtracks worsen the impression of incompetence rather than alleviate it.

The Lex team is interested in hearing more from readers. Please tell us what you think of the gilts rally in the comments section below.