Rising gilt yields point to another UK recession
The Bank of England's inflation forecast was wide of the mark
Earlier this week, inflation in the UK exceeded projections and gilt markets sold off sharply. The Bank of England forecast that inflation would fall from 10.1% in March to 8.4% in April, but they missed the target and inflation only fell to 8.7%. Most of the decline was due to a widely expected adjustment in energy prices, but other components such as food and retail remained stubbornly high.
The self-off in the gilt market that was triggered by this inflation print means that gilts are now priced similar to how they looked after Liz Truss’s disastrous mini-budget, in which the Government announced a raft of tax cuts. These tax cuts spooked markets, which quickly dumped gilts. This in turn caused turmoil in the pension and sterling markets.
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The sell-off this week has been nowhere near as sharp as what happened after the Truss mini-budget. But it means that the UK has higher borrowing costs than most European countries. The interest rate of a 10-year UK Government bond is around 4.4% — much higher than Germany (2.5%) and France (3%), and only really comparable to Italy (4.3%) which has long been seen as one of the riskiest borrowers in Europe.
The main cause of this is the higher relative inflation rate in Britain when compared with Europe. The EU average inflation rate in April clocked in at around 8.1% against Britain’s 8.7%. Some are quick to blame this on Brexit, but, really, it is due to wage pressures in the UK. A wave of strikes — cheered on by the same people blaming Brexit for the inflation — has ensured that a wage-price spiral has taken hold in Britain. This spiral occurs when workers refuse to take the hit on living standards caused by inflation and demand higher wages, but the higher wages are just passed on to consumers in the form of even higher prices.
But focusing on the wage-price spiral ignores the bigger picture. The British economy is simply not well placed to deal with inflation and instability. Manufacturing in Britain has fallen from making up around 20% of GDP in the early-1980s to less than 10% today. Britain plugs the gap with services, mainly financial services in the City of London. But because this is essentially shuffling paper, the British economy runs a persistent trade deficit. Since 2000 the country has had a trade deficit of anywhere between -2% to -6% of GDP.
This is a highly unstable economic model. If the markets ever decide to dump the City, sterling will fall in value precipitously, and the trade deficit will be forced to close by a large contraction in domestic consumption. That means a significant decline in living standards for the average Briton, making the current wage-price spiral and the action in the gilts market even more concerning. It is no wonder that the Bank of England seems intent on getting the situation under control, signalling that more rate hikes are almost definitely in the pipeline. More rate hikes, however, likely mean a recession in the near future.
So what ?
This is happening – and necessary – because the B of E simply didn’t do it’s job for the last15 years. They specifically had one target – 2% inflation – and repeatedly ignored this because they decided it was more important to “avoid a recession”/”support the economy”/prop up inflated house prices.
They had one job. They repeatedly failed. And yet no one ever got fired or resigned.
We are paying for that now. And rightly so. The cumulative bill for the pain we’ve ducked for 20-30 years is finally falling due.
The really sad thing is those who will pay the bill are largely a generation younger than those who ran off with the loot.
And can we please get away from this puerile nonsense that recessions are “bad” and must be avoided at all costs. They help clean all the dross out of the economy and reset things from greater efficiency and growth. Bad businesses have to fail if we want higher growth.
Problems don’t just go away because you pretend they don’t exist. The UK has always had a problem with inflation that we never properly addressed. We just got away with it for the last 25 years by the lucky accident of importing cheap labour and the arrival of cheap Chinese manufacturing. Those drugs have now worn off.
Not sure about this analysis. You can see exactly the same 0.4% spike in 10Y US Treasury Notes not to mention Canadian, French and Australian bonds. All started on 15th May. Almost certainly related to the debt ceiling negotiations in Washington.
As for recessions, I see the Germans are in recession while the UK isn’t. This is despite the widely published IMF forecast that Britain would be the weakest economy in the EU.
Valid points MM. We are not alone, albeit our GDP still lags others recovery from pre-pandemic, and our inflation a bit higher. Suggestive we have some unique issues.
Leaving the obvious Brexit to one-side, the issue seems to be more unique labour market issues. Not just strikes etc, I mean France got that with knobs on too, but labour shortages in key areas which could ratchet in wage-pull inflation here much more invidiously. Multiple drivers of course, but not quickly resolved. One worries the international markets see that, and tackling it likely push us into recession.
Others have issues too. US looks likely to hit recession late 23, but probably comes out fairly quickly afterwards. Germany clearly got problems too as noted.
This article shows only that Economics is an art, not a science – despite the plethora of figures in the various theories and projections.
Of more, and added concern is the comment by Britain’s largest gilt purchaser at the long end Legal and General ( Itself a raid/ takeover target now due to a woefully low share price) that it will long be buying more long dated gilts, due to ” uncertainty. Aside from a heap of ” pot calling kettle black” , we are back near the Callaghan times when the then gilts brokers and institutions effectively used their power to rid us of a Labour government in crisis.
We now have a socialist Callaghan equivalent government under a Tory banner, and a broken dysfunctional country worse than 1979,
There are , or would be, simple solutions, such as non gilt long term quasi government bonds to fund health/ infrastructure, but the above show that faith in the government AND The Bank of England and HM Treasury has gone.
The quality of personnel in both is low grade, quasi politicised, and underpaid, in stark contrast to those in the US equivalents.
Whilst politicians maintain a gutless ” keep my job at any cost” devoid of moral courage, belief, sense of duty, we will continue our plunge to being a sub Saharan African country look and live alike. A tragic disgrace.
If you think LGEN (Legal and General) is undervalued, buy the shares. It certainly was in March 2020 after Covid bombed the stock market. 8.5% dividend yield either means it still is or something nasty’s about to happen (it was 15% in March 2020). [Not offering financial advice and you’d be unwise to take it from me].
Yes, when you have Hunt the socialist Chancellor saying “Recession? yes please anything to bring down inflation” you know we are in trouble. It hasn’t concerned him that recessions create unemployment / higher benefit costs and reduce income from Business taxes.
Pilkington talking up the demise of a western nation? Surely not!
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