James Klempster discusses what has driven the movements in the gilt market this week and what the U-turn on welfare cuts means for government finances, taxes, borrowing and therefore the economy.
So what caused the gilt sell off this week and then following that, the pretty rapid recovery?
It was actually Prime Minister's questions on Wednesday where the Prime Minister didn't do a particularly robust job of defending Rachel Reeves and didn't say outright that she would remain in her job as Chancellor. It has happened subsequently and as you would have seen the gilt market has actually responded well to that. So the message in all of this from the market is less about the U-turn and the uncertainty and indeed the concern that there is going to be a greater challenges to balance the books, which are all valid concerns, but they weren't really what caused the market sell-off over the course of Wednesday. The main cause was uncertainty as to whether the Chancellor will remain in her post, and the point of that being ultimately more political upheaval and the greater risk of course, of somebody who's perhaps less disciplined coming into that post. And since the risk of that has seemingly diminished as the week's gone on, the gilt market has actually performed better and yields have almost equalised back to where they started the week as of today.
Well, we speak a lot in these videos about politics not really having a big impact in terms of markets, certainly over the long run, but over the short term, politics can cause significant uncertainty, significant changes in sentiment and changes in mood, and these can feed through into market prices and most notably over the shorter term. So we saw that change in gilt yields over the course of the week, pretty substantial, but also it was getting a little bit overblown in many ways the yield moves. We only went back to the sorts of levels we saw earlier this year, back to January levels really. So it wasn't an exceptionally big move and certainly not of the sort of scale and rapidity we saw around Liz Truss in 2022. [This is a long way from that, but it was a clear signal from the markets that you can't be wild in terms of budgetary largesse. And the Chancellor who is careful, Rachel Reeves, was still very much in favour in order to not do that. The government though has over their term got a tricky balance to achieve. And anyone in government would have the same struggles between spending and balancing the books by reducing spending. Or raising more revenue either through taxation or by borrowing more. The taxation, clearly, we've already started down that track, not necessarily very popular, but that's a way of raising revenue. The other impact, of course, if you overdo the taxation, you can start slowing the economy. There's an argument, you've seen some of that already this year, but certainly further tax rises risks that even more so. On the borrowing side though, the risk there really is you're presumed to be a poorer credit, you've matched out your credit cards, you're going and getting another one, in which case your ability to repay becomes less reasonable. And as we said last week when it comes to the US, ultimately these things are based on trust and if the belief around the markets is that your ability to repay is diminishing, the trust can evaporate fairly quickly and then you would see yields rising, currency weakness and other things as well. So there are risks associated with this which obviously the government will be acutely aware of and trying to navigate as astutely as they can but as of today that risk has been viewed as being diminishing in significance over the second half of this week but that over the medium to long term that is something that really needs to be borne in mind when thinking about the gilt market particularly as you know we've got a a challenging budgetary position, but as do many other developed markets today as well.
In terms of the portfolio impact, we've actually over the course of year-to-date, been reducing our gilt allocation. We still remain fairly constructive on gilts. We have them scored as a 3 out of 5. So we're neutral on our gilt position, but we've made the decision strategically rather than tactically. The shorter term allocation is tactical strategically over the long-term to reduce our gilt allocation to diminish the significance of the yield policy and the yield curve, as we call it in the UK, particularly in the portfolios, and keep a basket of more global government bonds in there to reduce that idiosyncratic risk to any one geography, any one political environment, and indeed any one fiscal environment. So over the course of this year, we've actually been reducing our gilt allocation in favour of a more diversified global bond exposure. That's it from me, have a good weekend when you get there and we'll see you next time.
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