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Making sense of brexit, bond yields and break-evens

The latest in a series of columns from Adam Chester, head of economics,

Lloyds Bank Commercial Banking

Photos © Joel Chant - www.joelchant.com UNP- 34198 - Lloyds banking Group portraits, 10 Gresham St London

SHARE PRICES at record highs. The pound at new lows. And the cost of government debt rising as the spectre of inflation returns.

It’s been quite a few months for investors since the Brexit vote, so what’s going on?

It’s certainly the case that investors are demanding a higher return or yield, to compensate them for the risk of holding sterling assets such as the pound and gilts (UK government bonds) – but we suspect the explanation is actually rather more nuanced.

While the pound has undoubtedly been hit by Brexit uncertainty, there is no sign in the equity markets, or the bond markets for that matter, that investors are demanding a higher premium for holding stocks.

Since the start of this month, all three UK benchmark indices – the FTSE 100, 250 and All-Share – have hit new highs.

If investors were truly concerned about the Brexit risk of holding UK government bonds, it should be reflected in a rising real yield. But it isn’t.

Markets are more concerned that inflation will rise over the coming years.

Inflating concerns

The sharp fall in the pound will lead to higher import costs and eventually to higher inflation.

Adding to bond investors inflation fears is the recent rise in energy prices which are priced in (stronger) dollars.

The two together have sent gilt prices lower and yields higher.

But while it is reasonable to expect these developments to push inflation up sharply over the next year or two, for this to have a more sustained impact there would need to be a more generalised rise in prices and wages.

To us, this is something that looks less likely to occur over the medium to longer term, given the risks to UK economic growth.

But while rising inflation expectations are part of the story, we suspect other factors are also at play.

The whole story

In particular, it is likely that bond yields have been pushed higher by emerging doubts over the likelihood of further central bank stimulus and growing expectations that government borrowing, or fiscal policy, may end up doing more of the heavy lifting.

A lack of liquidity in the bond market and the peculiarities of pension fund hedging are at least partly responsible.

It is easy to blame the EU referendum decision and the fall in the pound for the rise in inflation expectations, but it is more difficult to reconcile what is effectively a relative price move in the currency – and oil prices – with a sustained pick-up in inflation.

In short, while Brexit concerns may easily explain the fall in the pound, it doesn’t fully explain the rise in bond yields.

There are other reasons why bond yields and inflation expectations are moving higher – so let’s not blame it all on Brexit…

Adam Chester is head of economics at Lloyds Bank Commercial Banking

 

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