UK bond market braces for more losses after Truss energy plan By Bloomberg

(Bloomberg) – Prime Minister Liz Truss’ plan to spend billions of pounds to cap energy prices could help protect British households this winter, but for investors in British government bonds there is no has that more pain in store.

Investors eased bets on the Bank of England’s interest rate cut next year after the Prime Minister’s first major policy announcement last week. They also fear that longer-term bonds will suffer from rising inflation expectations and increased government borrowing.

The bailout of Truss could add around £200bn of additional gilt issuance this financial year and next, according to Deutsche Bank AG (NYSE:). This is bad news for a market already struggling with the fastest pace of inflation in 40 years. The British central bank has indicated that it will act “forcefully” to rein in prices by tightening its monetary policy.

“I think the amount of additional debt, the greater risks around the twin deficits will mean higher returns going forward,” said Howard Cunningham, portfolio manager at Newton Investment Management. “Capping energy prices will likely lead to lower headline inflation, but more persistent core inflation, as consumers continue to spend.”

He sees 10-year gilt yields dropping from around 3.5% to around 3% currently. They have already increased by 1.3 percentage points since the beginning of August.

Money markets reacted to Truss’ program by reducing short-term inflation expectations, but also anticipating that interest rates will stay high longer until 2023. Traders are betting on just 15 basis points of cuts from June to December 2023, against around 25 basis points. cut points over the past month.

The BOE has delayed its next rate decision by a week until September 22 after the death of Queen Elizabeth II, giving policymakers more time to analyze Truss’ energy plan as well as key employment data and inflation which should be published next week.

Economists at JPMorgan (NYSE:) Securities, BNP Paribas (OTC:) and Credit Suisse are already anticipating that the BOE will deliver a 75 basis point hike in the base rate to 2.5% this month. That comes on top of the half-point rise in August, the biggest increase in 27 years.

Policymakers have two conflicting forces to assess in the months ahead. Truss says his plan to freeze energy bills will reduce the headline inflation rate by up to 5 points, which economists polled by the Treasury say will peak at around 15%. The concern is that cushioning consumers now will add to the strains in the economy and drive up prices later.

“Recent measures are bringing inflation down in the near term and could reduce the BOE’s urgency,” said Rohan Khanna, rates strategist at UBS. “But it may mean stiffer inflation as purchasing power is less affected than previously thought, so less easing after a rate spike.”

Higher rates in financial and BOE markets would add to the strains facing consumers, who are grappling with the worst squeeze on their purchasing power in a century.

The timing of the next BOE decision adds to the complexity of the assessment. Policymakers were due to meet on September 15, before Chancellor of the Exchequer Kwasi Kwarteng is expected to provide more detailed estimates of the cost of the Truss energy package. By delaying a week, it is possible that the BOE will now decide rates after seeing these estimates.

The BOE also planned to use this month’s meeting to confirm sales of some of the bonds it accumulated during the years of quantitative easing, when it amassed £895bn of assets to boost the economy. Those sales could now collapse over Kwarteng’s own fundraising plans.

“This will mark a huge shift in net gilt issuance that will come up against quantitative tightening and Bank of England hikes,” wrote Citigroup (NYSE:) strategist Jamie Searle in a note to clients.

NatWest Markets UK rates strategist Imogen Bachra sees a “regime shift” for gilts due to these headwinds, forecasting 10-year gilt yields to hit 4% by year-end . Gilts could also suffer from lower demand from pension funds and foreign investors, according to HSBC.

A remark earlier this week by BOE chief economist Huw Pill that the Truss plan would reduce inflation in the immediate term was interpreted as a dovish sign and led to a rise in gilts to two year. But this is offset by the BOE’s ambition to quickly bring inflation back to its 2% target.

“The Bank of England will likely still feel under immense pressure to prove its commitment to bringing inflation back, and a 75 basis point rate hike next week is a very real possibility,” said Hugh Gimber, Global Markets Strategist at JPMorgan Asset Management.

This week

  • There are no speeches from BOE policy makers scheduled due to an extended period of “silence”. However, European Central Bank officials will be out in force with scheduled speeches, including from Philip Lane and Isabel Schnabel.
  • UK inflation figures for August and July growth figures as well as employment and wage data will also be watched.
  • Germany’s ZEW September survey will be closely watched for business sentiment clues ahead of the following week’s Ifo figures. Otherwise, the data is mostly second-level and retrospective.
  • Bond sales from Germany, Italy, France, Spain and Portugal are expected to total nearly 30 billion euros ($30.2 billion), according to Commerzbank AG (OTC:), which reports that the EU and Belgium could sell debt via the banks. The UK will not sell bonds this week.

©2022 Bloomberg LP

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