Who would have thought that Brexit would result in a convergence of the European and UK bond markets.
With the UK swept by a debate whether it should follow Europe into negative interest rates, the bond market appears to have made the decision for it, when this morning the UK sold £3.75 billion in 2023 gilts at a negative yield of -0.003% for the first time, with a fall in inflation piling even more pressure on the fiscal and monetary policymakers to take new action to prop up the economy.
The UK drew orders of £8.1bn in Wednesday’s auction resulting in a 2.15 bid to cover to the amount the DMO was looking to sell. According to the FT, "the robust demand underscored the appeal of gilts, long considered to be a haven due to the UK’s strong creditworthiness. It also suggests any fears over the large increase in borrowing the UK has undertaken due to the Covid-19 pandemic has not yet weighed on investor appetite for the debt."
The auction comes during the growing debate into whether the BoE will need to reduce its main interest rate from its already historic low into negative territory, as policymakers attempt to bring inflation back towards the 2% target. Whatever you do, don't look at Japan.
The negative yield means investors who hold the debt to maturity will get fractionally less than they paid, and are paying for the privilege of lending to the UK government, reflecting growing investor expectations that the Bank of England may need to take additional steps to push inflation back to its 2 per cent target. The UK sold a one-month bill at a negative yield in 2016, but this represents the first time it has sold a conventional longer term bond at yield below zero.
Moyeen Islam, rates strategist at Barclays, said the auction was a "symbolic hurdle" noting that "given recent comments from monetary policy committee members, the question of negative policy rates is far from settled."
While other central banks have already used negative rates they have faced stinging criticism, especially from bankers since it weighs heavily on the profitability of their traditional lending operations: "I can’t think of an economy where negative rates are a worse idea than the UK," said SocGen FX strategist Kit Juckes. "The economic benefits are dubious but the power of a cocktail of negative rates and massive quantitative easing to weaken the currency seems clear and if the pound falls enough, it will make QE harder."
Separately, also on Wednesday UK CPI inflation crashed below 1%, nearly halving to 0.8% last month from 1.5%, missing consensus expectations and the lowest level in almost four years.
According to Nomura, the most important reasons behind the fall were: 1) falling household energy bills, where the lower price cap in April led to a 3.6% m-o-m drop in gas bills versus a 9.2% m-o-m rise in April last year (as a result household energy took nearly 0.4pp off headline inflation between March and April), 2) the largest fall yet in petrol prices in response to lower oil prices since the start of the year (a fall of nearly 8% m-o-m versus a 2.6% m-o-m rise in April last year, taking 0.3pp off headline inflation) and 3) a regulatory-imposed reduction in household water bills (down 1.7% m-o-m compared with the April 2019 monthly rise of 2.7%). Taken together those three factors can account for pretty much the entirety of the 0.76pp decline in headline CPI inflation between March and April. Economists have warned the shock to demand caused by lockdowns could cause a wider disinflationary trend.
Against the backdrop of a protracted period of below-target inflation, and in order to preempt any liquidity disruption in bond markets associated with the exhaustion of the MPC's existing asset purchase program, Goldman said it "continues to expect the Bank of England to announce an additional £100bn of quantitative easing at its next decision on 18 June."
"With inflation now more than 1 percentage point below target, the governor of the Bank of England will . . . have to write a letter to the Chancellor explaining why inflation is so far below target and what he intends to do about it,” said Melanie Baker, senior economist at Royal London Asset Management. “The next step we expect to see is more asset purchases."